Chapter 16

16.1 Securities in construction

Numerous risks burden construction projects. These risks should ideally be allocated to the project participants (mainly to the contractor and the employer) based on their respective abilities to control them. The parties should insure themselves against individual risks but this is not always possible because some risks are non-insurable. In general, non-insurable risks include the risk that the contractor will fail to perform in accordance with the contract (executing the works and remedying the defects within the defects notification period) and the risk that the employer will fail to pay. An exception to the former is the so-called Subcontractor Default Insurance used in the US. If participants cannot insure risks by way of an insurance policy, they may secure them by contractual means or further specific instruments. Examples of the former include contractual penalties and retention money. Examples of the latter include bank documents such as letters of credit, stand-by letters of credit and bank guarantees.

The bank guarantee has become so popular during recent decades that it now appears in most standard forms of contracts in large construction projects. The principle of bank guarantees is that the bank will pay to the contractor or employer (at their request) a pre-agreed sum that will compensate adverse implications of the failure to act or of defective performance by either of the parties should the contractor or the employer fail to meet their obligations.

The requirement to issue such guarantees may sometimes come not only from the contract itself but directly by law. This is the case in the event of a guarantee for payment for the works in accordance with Umowy o roboty budowlane (Contract for Works) in Poland or where the public contracts are to be secured; for example, in Germany or the US.

16.2 Bank guarantees

A bank guarantee is a versatile financial instrument which allows both financial and the non-financial obligations to be secured in national and international contracts entered into by legal (corporate) persons or natural persons as contractors or employers.

The most frequent types of guarantees in practice secure the duty to sign the contract by the contractor, contractor performance, employer advance payment, contractor duty to repair defects in the defects notification period and the guarantee that is used in place of retention money. Contractor guarantees are mainly for non-payment obligations to secure their performance. On the employer’s side, there are payment guarantees securing the employer’s duty to pay for the works, goods or services received. Note: the above guarantees may be known by other names, depending on the jurisdiction.

The building construction and civil engineering industry rank themselves among the largest ‘users’ of bank guarantees in terms of their amounts and frequency of use. The most common types of guarantees used in construction are tender guarantees (bid bonds), i.e. security of the contractor’s duty to sign the contract.

Regarding bank guarantees, a new party (the guarantor) with well-controlled and declared credit stands between the contractor and the employer. The guarantor secures the contractual duties of the parties in case of breach of contract. Should one of the parties fail to perform, the guarantor shall pay an agreed amount to the other party. The force of security is further enhanced by the abstract nature of such a bank guarantee and by the bank’s duty to perform on the first demand without any objections. It implies, in practice, that the bank does not inquire into whether or not the breach of the contract really occurred and, further, is not even entitled to raise objections which the parties might otherwise raise between themselves.

16.3 Functions and parameters of bank guarantees

16.3.1 Vadium/Tender Guarantee/Bid Bond

  • Beneficiary: The employer
  • Ordering party: The contractor
  • Amount: 1–5% of the future contract price
  • Purpose: To secure the contractor’s duty to sign the contract
  • Substantial validity: Expiry of tendering period/validity of tender.

A tender guarantee will protect the employer against the risk that a contractor (the participant of the tender) becomes disinterested for any reason whatsoever, withdraws their bid prematurely, fails to sign the contract or to observe the parameters of their bid. The employer is thus compensated for the cost arising from the postponement of execution of the works, re-tendering, and so on. Submission of such a guarantee is often a precondition for admission to a particular public procurement.

16.3.2 Advance Payment Guarantee/Down Payment Guarantee/Advance Payment Bond

  • Beneficiary: The employer
  • Ordering party: The contractor
  • Amount: 5–30% of contract price
  • Purpose: To secure return of the advance payment should the contractor fail to perform
  • Effectiveness clause: Effectiveness of guarantee is usually subject to payment of an advance payment to the contractor’s particular account kept by an issuing bank
  • Substantial validity: Foreseeable time for completion of delivery (+30 days).

This guarantee will find its application in construction projects with the contractor being funded by means of advance payments. The guarantee will secure to the employer return of the advance payment for the unaccomplished part of the obligation for which the advance payment had been given.

16.3.3 Performance Guarantee/Final Guarantee/Performance Bond

  • Beneficiary: The employer
  • Ordering party: The contractor
  • Amount: 5–10% of the contract price
  • Purpose: To secure fulfilment of the contractor’s contractual obligations
  • Substantial validity: Until completion of the contract works (signing of the Taking-Over Certificate +30 days).

This guarantee secures the risk that the contractor may, for any reason whatsoever, breach their duty to complete the works. The guarantee is to cover, for example, the cost incurred in connection with such non-completion. The employer will usually require the security once the contract is signed or shortly after.

16.3.4 Warranty Guarantee/Maintenance Guarantee/Maintenance Bond

  • Beneficiary: The employer
  • Ordering party: The contractor
  • Amount: 5–10% of the contract price
  • Purpose: To secure the contractor’s contractual duty to repair all defects within the defects notification period and protect the employer against the contractor’s unwillingness or inability to remedy the defects
  • Substantial validity: Duration of the defects notification period.

This type of guarantee is required by the employer for works, plant, and so on for which a defects notification period has been agreed. If the contractor fails to remedy the defects within this period, the employer will use the guarantee to acquire funds to remedy the defects using the services of another contractor, if any.

16.3.5 Retention Guarantee/Retention Bond

  • Beneficiary: The employer
  • Ordering party: The contractor
  • Amount: 5–10% of the contract price
  • Purpose: To secure the contractor’s contractual duty to repair all defects within the defects notification period
  • Effectiveness clause: Effectiveness of the guarantee is usually subject to payment of retention money to a particular account (usually at the issuing bank)
  • Substantial validity: Completion of a certain stage of the project, expiry of defects notification period.

This guarantee is applied where the employer withholds, during the course of a construction project, a certain amount (retention) from payments to the contractor. If, however, the contractor wants to get the retention earlier, they may submit the bank guarantee at the level of the pre-agreed retention with the employer’s consent.

16.3.6 Payment Guarantee/Payment Bond

  • Beneficiary: The contractor
  • Ordering party: The employer
  • Amount: As per contract (e.g. the full contract price, its portion, and so on)
  • Purpose: To secure the employer’s duty to pay
  • Reduction clause: Each time after a partial payment is effected
  • Substantial validity: 30 days after maturity of the final payment obligation.

This guarantee will secure the contractor against the employer’s insolvency. The validity of such a guarantee is always limited by a fixed date. The term of validity expresses exactly when the rights of the guarantee beneficiary will expire and the timeframe for which the bank remains obliged to this beneficiary.

16.4 Specifics of Retention Guarantee

Retention guarantees are commonly used in construction projects. Retention, or the money withheld, is perceived as a portion of the contract price the employer will ‘retain’ and pay to the contractor once the works/goods/services are taken over or in response to an interim invoice. This will be at some later date set out in the contract (such as after completion of a certain stage of the project, once a milestone is fulfilled or defect notification period expires). The retention is usually determined as a percentage and forms part of the agreed payment conditions.

The reason behind ‘withholding’ a portion of the contract sum (usually at the level of 5–10%) is the employer’s endeavour to secure fulfilment of the conditions of contract on the side of the contractor and to protect themselves against the contractor’s unwillingness, lack of will, or impossibility of remedying the defects within the defects notification period.

The parties can agree on earlier payment of this retention – usually upon taking over of the works or once a certain milestone is achieved but provided that the contractor submits to the employer a bank guarantee in place of retention at the level agreed in the contract. This will favour the contractor; allowing them to improve their cash-flow because they will receive the retention earlier than they would be entitled to in accordance with the contract. This helps to protect the contractor against the employer’s lack of will or impossibility of paying that could emerge after the defects notification period expires. Because of the significant length of the defects notification periods used in construction projects, the contractor is partly protected against inflationary impacts as well. The advantage for the employer is that they have the option to request payment should the contractor fail to meet their obligations because of bankruptcy.

In respect of the fact that the beneficiary can use the guarantee in the event of lacking, improper or untimely performance of the contractor’s obligations under the contract, the retention guarantee serves, therefore, a similar purpose as the performance guarantee or the maintenance guarantee.

The retention guarantee is usually required when the taking-over certificate is signed, unlike the performance guarantee which is usually required by the employer shortly before the contract is signed and which generally secures performance in accordance with the conditions of contract, i.e. to deliver on time and at the required quality.

The different nature of the retention guarantee versus the maintenance guarantee can be seen by the absence of any cash flow between the contracting parties through the maintenance guarantee. Substantially, both guarantees secure identical obligations, i.e. fulfilment of the contractor’s duties as they arise from the agreed defects notification period.

As a rule, retention and advance payment guarantees include a clause on their postponed effect from the moment when the retention is actually credited to the contractor’s bank account. For example:

Claims from this bank guarantee issued under reference of……can be raised only provided that the retention at the level of……will be credited in full to our client’s account no.……kept by our bank…….

A less frequently used (and more problematic) alternative may be crediting the retention to an account kept by a bank other than the bank providing the guarantee. A problem will arise if an amount other than the one determined by the guarantee is credited, even though the difference may only be marginal. The circumstances under which the ‘other’ amount (which is not expected by the parties) can be credited may relate to, for example, subtraction of the bank fees, rounding errors, inclusion of mutual debts and liabilities, and so on. Whenever the conditions upon which a bank guarantee is to be effective are agreed upon, it is usually in the best interests of the beneficiary that the issue is taken into account so they can be sure about the effectiveness of the bank guarantee.