When you think of performance security under a construction contract, cash retentions and bank guarantees come to mind. However they are not your only options.
1. Cash retentions
Perhaps the most common form of security, particularly for smaller contracts, involves cash retentions.
This involves withholding a small amount from the contractor's claim (typically 10% of the claim), until a certain value of security has accumulated (typically 5% of the contract sum).
One of the main benefits of a cash retention arrangement is its simplicity. However a downside for the contractor can be the effect on the contractor's cashflow.
Head contractors also need to keep in mind the recent decision in Maxcon, which determined that a retention arrangement will not be effective where the obligation to release the security is dependent on the operation of another contract (such as a head contract).
2. Separate bank account
As an alternative to cash retentions, sometimes the security amount will be paid into a separate bank account - potentially being an account controlled by both parties, or a solicitor's trust account.
The purpose of this arrangement is to give the contractor greater comfort that it will eventually receive the security amount, once its obligations have been discharged.
Like cash retentions, the main disadvantage for the contractor is the impact of this arrangement on its cashflow.
Several States have started to mandate project bank accounts as part of their security of payment legislation, on Government projects or projects above a particular size. Some of these regimes (eg in Queensland) contemplate a specific bank account being set up to hold retention, essentially on the basis set out above.
3. Bank guarantee
A bank guarantee is an undertaking given by a bank to pay an amount on demand to the named beneficiary.
Banks will typically take security from the contractor (often in the form of cash) to ensure they are protected if the bank guarantee is called upon.
Many contractors prefer bank guarantees to cash security, principally to avoid the negative impact on cash flow associated with cash retentions.
4. Insurance bonds (or surety bonds)
Insurance bonds are similar to bank guarantees, in that they are issued by a third party financial institution (usually an insurance company), and are payable on demand to the named beneficiary.
The difference between a bank guarantee and an insurance bond is that issuers of insurance bonds do not typically require the bond to be secured by cash deposit. The consequence is that insurance bonds are usually better for the contractor's cashflow. The downside is that the upfront costs associated with an insurance bond are often higher than those associated with a bank guarantee.
5. Related party guarantee
A related party guarantee is a formal guarantee given by a person or entity related to the contractor, such as a director, shareholder or related body corporate (usually the ultimate holding company).
The main benefit to the contractor is that a related party guarantee has no cashflow consequences. The trade-off is that the guarantee can put other assets at risk, outside the contracting entity.
From the perspective of a principal or head contractor, a related party guarantee is an inferior form of security to a bank guarantee, insurance bond or cash retention. This is because:
- a related party guarantee is only worth as much as the party giving it; and
- a related party guarantee is much more difficult to enforce than a bank guarantee or insurance bond.
To call on a bank guarantee or insurance bond, the beneficiary will need to present the original guarantee or bond to the bank, along with a letter demanding payment. The issuer of the guarantee or insurance bond is then immediately bound to make the payment, and this typically occurs within a matter of days.
Although a related party guarantee is intended to work much the same way, in practice this rarely occurs. Most of the time, this is because the interests of the related party are aligned with the interests of the contractor.
Whereas the position of a bank or insurance company is neutral, it is not uncommon for the guarantor under a related party guarantee to seek to find ways to avoid payment. As a result, litigation is often required to obtain the benefit of a related party guarantee.
6. PPSA Security
The introduction of the Personal Property Securities Act (or 'PPSA') in 2009 brought in radical changes to the laws around title to and ownership of personal property, including retention of title arrangements.
The PPSA allows you to take an effective security interest in items of personal property - such as specific materials, plant or equipment, or even a contractor's assets generally.
To create an effective security interest under the PPSA legislation, you must do two things:
- enter into an agreement that creates a security interest; and
- register your interest on the Personal Property Securities Register (or 'PPSR'), which you can find here.
There are formal requirements that will need to be satisfied, and strict timeframes for registration.
PPSA security interests are commonly used to secure pre-payments or deposits for specific goods. They can also be used more broadly.
Because of the complexity of the PPSA and the importance of registration, most parties seeking security under the PPSA seek the assistance of lawyers who work in this area.
7. Letter of comfort
A letter of comfort is an assurance given by a third party, such as a bank, accountant or related body corporate, about the financial standing of a particular entity.
A letter of comfort is not 'security' in the strict sense.
The value of a letter of comfort depends on what is said. For example, if the letter misrepresents the financial position of the contractor, if it makes representations about future matters without having a reasonable basis for doing so, it could find itself liable for a breach of the misleading and deceptive conduct provisions of the Australian Consumer Law.
A letter of comfort is typically regarded as an inferior type of security.
8. Longer payment terms and offsetting provisions
Extended payment terms can also provide a form of informal security to a principal or contractor (not unlike an interim form of cash retention), provided:
- the contract contains appropriate off-setting provisions;
- the security of payment legislation does not prevent you from off-setting the amount (noting that this can be a particular problem under the Victorian security of payment laws); and
- your payment terms are not longer than any maximum payment terms prescribed by statute (for example, in NSW the maximum timeframe is 15 business days for head contract claims and 30 business days for subcontract claims).
Where off-sets are not prohibited by the security of payment legislation, care should be taken in drafting the relevant provision to ensure that the value of any progress payment under the contract must take into account the value of the off-set. Otherwise, the offset may not be effective.
9. Mortgage over land
Although unusual, a mortgage over land could be used as security under a construction contract, in the same way that a bank takes a mortgage over land to secure a loan.
Mortgages are rare in this context because:
- the parties will normally be able to agree on a different regime, without having to resort to a mortgage; and
- contractors are not typically inclined to grant this type of security.
A combination of measures
There is no one-size-fits all approach, and sometimes a combination of measures may be appropriate.
The larger the contractor you are dealing with, the easier it will be for them to provide security.
The options for smaller contractors are often more limited, because banks are unwilling to afford them the same accommodation as larger, more established companies, and also because they have tighter cashflow constraints.
The point is that, if you are unable to obtain your ideal form of security, think about a variety of measures instead. There are a variety of levers you can pull, some of which will be more palatable to the contractor than others.
Also keep in mind that something is usually better than nothing. The risk of insolvency in the construction industry is very real, and the insolvency of a contractor on any project can have significant consequences for all project stakeholders.