Payment security: A two way street to avoid a road to nowhere?

This article was produced by Nabarro LLP, which joined CMS on 1 May 2017.

In the depths of the recession as the futures of even some of the biggest names in the construction industry were starting to look uncertain, employers were in the privileged position of being able to require a suite of security documentation from contractors to protect them against non-performance and/or insolvency. It pretty much became standard practice to require both parent company guarantees and performance bonds on major developments, regardless of the brand name of the contractor.

During that time parent company guarantees typically matched the 12 year limitation periods of the underlying building contracts, allowed for recovery immediately on breach (without the need for dispute resolution in respect of the underlying contract) and placed primary obligor obligations on the guarantors, with bonds remaining in place until the certification of making good defects.

Changes in an improving market

As the construction market has recovered we have seen a move away from this position, with the security packages being offered by contractors diminishing in scope and value, and a return to contractors requesting payment security from employers.

This shift started with employers ceasing to obtain both parent company guarantees and bonds, except where the particular circumstances of a project necessitated otherwise. Where bonds were still being offered they would often expire at practical completion and have a significant cost impact for the employer. Consequently, if parent companies were deemed to be of adequate covenant strength it was perceived by some that bonds were an unnecessarily expensive addition. Having secured a move away from almost always needing to provide both types of security contractors then started to look at the terms of parent company guarantees, insisting on amendments which diminish their value to employers and attempting to make parent company guarantees more akin to on-default performance bonds.

Bonds v parent company guarantees

By seeking to turn parent company guarantees into on-default bonds from group companies rather than third party bondsmen, contractors are ignoring that the two types of security are inherently different in nature with distinct advantages and disadvantages. To go back to basics, the often perceived advantage of bonds was the covenant strength of the bondsman which was not related to the financial performance of the contractor's group or, generally, the construction market. They were therefore valuable even if in certain cases recovery under them was cumbersome to obtain (with loss needing to be proven, often through formal dispute resolution, before a call could be made) and if protection ceased at the certification of making good rather than extending to cover latent defects down the line.

Conversely, parent company guarantees were typically easier to claim under and had the added benefit of providing protection matching the length of the contractor's duties under the underlying construction contract. They were thus still worth obtaining even if the covenant strength of the parent was linked to the fortunes of the relevant contractor.

If the terms of parent company guarantees are now expected to be similar to the terms of on-default performance bonds then employers are left with the worst of both worlds: a covenant strength linked to the contractor itself and terms which make recovery difficult, and often time-consuming and expensive. In such circumstances employers need to be careful to ensure that parent company guarantees are actually offering a tangible level of security, as whilst the market has changed (so that contractors are in a better bargaining position on contract negotiations) financial concerns remain due to contractors' on-going commitments to deliver projects priced at the bottom of the recession at a time when supply chain prices are now soaring.

Payment security

Against this backdrop, with contractors being in a position to pick and choose projects as demand outstrips supply in certain markets, contractors are once again interrogating the covenant strength of employers with some contractors reviving requests for payment security from even the most well-known developer groups. In the past year we have seen the re-emergence of payment guarantees and escrow accounts, with rumours of employers even offering to cover tender costs to encourage bidding. We have also been asked to put in place a “reverse” performance bond to cover upstream payment obligations, with no appropriate industry form bond yet available to cater for this situation.

Conclusion

In this climate employers need to be careful to ensure that the "security" they are getting from contractors does actually offer them protection against issues down the line, and be aware that if they are expecting security of value from the contractor they may well be expected to offer the same in return.