Bonds and Bank Guarantees

In my February 6, 2011 post about managing supplier performance I mentioned some of the financial tools that can be used to help manage performance. Those included the use of items such as performance bonds, bank guarantees, liquidated damages provisions, penalties, releases of progress payments or a delivery date based pricing (with bonuses for early delivery, or credits for late delivery). Today I want to discuss performance bonds and bank guarantees.

A performance bond is a document usually issued by an insurance company (“Surety”) that normally will commit up to the full value of the contract to complete performance if the supplier fails to complete the work. Suppliers or contractors purchase the bonds from the Surety and the cost of the bond will be dependent upon how the Surety perceives the risk of the supplier performing which is largely based upon the contractor’s financial condition. If the supplier defaults, the buyer or owner will make a claim against the bond with the Surety. As a condition of the bond with the Supplier or Contractor, the Supplier will commit to assign the contract and any subcontracts to Surety. As a condition of collecting on the Bond the buyer or owner must agree to allow the Surety to finish the work or hire someone to finish the work. The Surety’s primary goal is to complete the work for the lowest possible cost to reduce the amount they have to pay.

A bank guarantee is different. Normally to obtain a bank guarantee the supplier or contractor will either need to have money in deposit at the bank that will be used to provide the guarantee or they may need a line of credit with the bank that is secured by the Supplier’s assets. Bank guarantees, since they are tying up either the supplier’s actual cash or a portion of their available credit will be much lower, many times as low as ten percent (10%) of the contract value. Bank Guarantees can be direct where payments are made to the holder of the guarantee or they can be indirect where payment would be made to the holder’s specified bank. The specific conditions and process for collecting against the bank guarantee would be spelled out in that document so you need to read it so you see exactly what you are getting and whether that meets the requirements of your agreement for the bank guarantee. Bank guarantees could specify similar requirements to a performance bond where they would be involved to manage the amount paid.

While you could technically require both a bank guarantee and a performance bond where the bank guarantee would be like a deductible to the performance bond, most suppliers wouldn't agree as that both ties up their money or available line of credit and the bond adds additional cost.

While both performance bonds or bank guarantees provide some degree of financial protection against default by the Supplier, many times buyers may not want to have a third party involved in the process whose sole goal is to minimize the cost of completion. If you want to control your own destiny without third party involvement, bonds or bank guarantees may not be a route you want to take. In that case your contracts need to include rights in the event of default. Those rights would be triggered by the supplier’s failure to cure the breach of the contract. Those rights could include hiring their personnel, use their equipment , and having assignment of all subcontracts to you to allow you to complete the work.

If that’s a direction you plan take you need a detailed qualification of the supplier or contractor before you start to minimize the risk. To make sure that you don’t have a large number of unpaid subcontractors the contract should require the supplier getting waivers and releases of liens from subcontractors for the amount of their work included in the prior invoice as a condition of payment to the contractor to make sure the contractor has paying the subcontractors. The agreement should include holding sufficient retainage at all times so if needed, you can use that money to complete the work. Lastly as bonds usually cost a percentage of the contract price, if you don't require them you also have that amount of savings you could add to what it takes to get the work done. Lastly, you also could claim breach and seek damages for both breach of the contract any for any excess costs to re-procure the completion of the work if the Contractor still had any money.