A familiar component of the contract procurement process is the provision of performance security that provides assurance to project owners that the contracted work will be completed as agreed. The need for such security is well documented and reflects the complex and risky nature of the construction business.
To address the security need, owners and contractors can be faced with a choice between traditional surety bonds and letters of credit (LOC). Additionally, parental guarantees are often included as a supplement or substitute for the security. These alternatives have unique implications that should be considered by contractors and owners when choosing the best path.
Surety bonds offer contractors significant benefits, such as serving as a separate source of credit, whereas LOCs by nature are part of the bank line of credit for a client. Surety serves as an important resource to help the contractor grow and expand its project base. Because they are underwritten by a surety company, surety bonds are an independent verification of the capability of the contractor. That third-party view is an integral part of a contractor’s competitive advantage and helps firms distinguish their project execution capabilities to prospective owners. An LOC is simply a line of credit that does not carry a contractor verification beyond a basic assessment of financial resources.
From a project owner’s perspective, surety bonds and LOCs offer different benefits. Surety bonds offer assurance that the contractor is capable of completing the contract on time, within budget and according to specifications. A significant characteristic of surety, often overlooked by owners, is that the burden of construction risk is shifted from the owner to the surety company. By contrast, LOCs simply offer a promise to pay on demand, but do not shift the construction risk and serve to keep that risk at the owner level.
Outside of North America, LOCs are a common performance security tool used by owners, developers and concessionaires. Typically, the LOC will be issued and used as on-demand project security in private and public construction procurement in Europe, Asia and Latin America. However the size of many projects in the United States and Canada requires a level of protection that LOCs cannot provide.
While project owners and others may think an LOC has an advantage over a surety bond because the instrument is payable on demand, LOC coverage is limited in several ways.
LOCs typically cover only 10 percent to 15 percent of project costs, while actual costs in the event of default tend to run much higher. This protection is significantly lower than surety payment and performance bonds, which typically cover 100 percent of the value of the project, depending on the scale of the job.
A contractor default on a large, complicated construction project unleashes an incredibly complex series of events that need to be managed before the project can resume work. If the LOC is called upon, it is usually during a crisis situation where different parties with competing interests are primarily concerned with vying for payment, and not focused on getting the project completed.
The LOC itself does not help get the project completed, whereas an experienced and knowledgeable surety team has resources to step in to expediently get the job back on track. An owner does not have the level of construction experience, nor does it maintain ongoing relationships throughout a project like a surety partner does.
LOCs do not contemplate managing claims and liens against a project, as the role of the issuing bank begins and ends with honoring a demand for payment.
U.S. construction is complex due to the size of projects, the challenging work conditions, and the many different subcontractors and types of workers. Experienced surety professionals deeply understand the nuances of the procurement process and project risks, and act as advocates for the contractor and the project overall. A contractor that has a strong relationship with a surety partner benefits from the surety knowing the total project and financial risks the firm is currently facing across its existing project portfolio. This insight helps the contractor determine the level of risk it will need to manage on a project.
Parental guarantees are another misunderstood performance security tool. The use of the general indemnity agreement is widely known and is the cornerstone of the surety relationship in the United States and Canada. However, when indemnitors and corporate parents of indemnitors are located outside of North America, new issues arise and parental guarantees are often used.
A parental guarantee is the indemnity of a corporate parent to reimburse a surety for losses and expenses from a subsidiary of the parent. Issues that arise in parental guarantees include:
- laws and regulations of the country of domicile of the parent;
- the form of the guaranty;
- specific provisions, such as net worth, long-term debt or other special covenants;
- timing, trigger and limits of liability of actual reimbursement; and
- legal requirements on document execution.
Additionally, the use of parental guarantees does not consider the prequalification of the contractor and that contractor’s ability to successfully perform. While parental guarantees can supplement the performance security provided by surety bonds, there is no established mechanism to manage a default and successfully complete the project.
The use of parental guarantees as a risk mitigation tool requires an in-depth knowledge of the local regulatory climate and a clear understanding of the expectations of all parties. When applied correctly, parental guarantees can be a valuable tool to manage and mitigate risk and meet stakeholder needs on construction projects in North America.
Robert Murray is head of surety for Zurich North America. For more information, email firstname.lastname@example.org.