Contractor Default Protection for Industrial Project Owners – Part 1

Skin in the game: a comparison of three common instruments used to address contractor default

Owners of multi-billion dollar industrial developments such as oil and gas facilities, mines or pipeline projects are involved with a myriad of different contractor disciplines and engage in contracts of varying size and scope. In doing so, these owners must manage the processes of their internal procurement, legal, and counterparty risk teams to properly assess and mitigate the risk of contractor default.

When determining how to structure internal protocol for dealing with the risk of contractor default, owners should create a deliberate approach with a thorough credit analysis and consider their own appetite for this type of risk. This article will show how three common instruments compare when used to address the risk of contractor default:

• Liquid Security
• Surety bonds
• Parental/corporate guarantees

All the aforementioned instruments ensure the contractor has a vested interest in performing their contract—that they have “skin-in-the-game”—as well as provide a form of potential financial recourse for the project owner. No two projects are identical, and the characteristics of a specific project will usually identify the most appropriate solution.

Liquid security

The most common form of liquid security used to guarantee contract performance are irrevocable letters of credit (ILOCs) issued by a bank. Some project owners also accept cash or other instruments such as securities on deposit and some may even increase the amount of holdback retained via the construction contract. 

A key issue to consider when using any form of liquid collateral as security is that each dollar held by the project owner has a direct dollar-for-dollar impact on the contractor’s working capital—the capital they have available to finance ongoing projects. In turn, owners generally ask for liquid security in amounts that are relatively small compared to the overall contract value (in the range of 5 to 10 percent).

Surety bonds

Surety credit is a three-party arrangement whereby a third party (surety) issues a guarantee to the project owner on behalf of the contractor. Surety is not insurance—it is unsecured credit extended by the surety in the form of bonds. The important element to recognize in the surety relationship is that the surety creditor plays a significant role in the prequalification of the contractor to complete the project as well as being completely involved in the process of remedying a claim for contract default.

The form of surety bond that guarantees contract performance obligations and protects against contractor default is the performance bond. The Canadian Construction Documents Committee (CCDC) has a standardized performance bond wording available for use by owners that is considered acceptable by the Canadian surety industry. Owners generally call for performance bonds with a penalty equal to 50 percent of the contract value.

In the event the owner claims under a performance bond, the surety has the choice of four options to respond to the claim (assuming the surety does not contest the claim):

1. Remedy the default.
2. Complete the contract in accordance with its terms and conditions.
3. Arrange for a new contractor to step in and complete the project.
4. Pay the owner.

Keep in mind that when owners use liquid security or parental guarantees in lieu of performance bonds they forego the opportunity to request labour and material bonds—surety instruments that guarantee the contractor will pay the subcontractors and suppliers tied to its contract. This is recourse that other stakeholders of a construction contract can use in the event of non-payment instead of filing liens on the project. Also, in the event the owner wants contractors to give pricing through a formal tender process, bid bonds and consents of surety can also be called for as a guarantee that the contractor will honour its bid price and furnish a bond(s) if awarded the contract.

A major benefit of surety bonds to an owner is at the back end of the surety relationship—the surety creditor underwrites the contractor with an ongoing in-depth prequalification process based on a comprehensive credit evaluation. This underwriting process will also directly pertain to the construction contract in question in both size and scope. Also, the surety-contractor relationship allows for “behind the scenes” solutions to contractor default that the project owner might never be aware of. To protect their exposure, sureties have been known to give their contractors short-term capital injections to help them through difficult financial times.

Using surety credit is a more involved process for a project owner than using a dormant instrument like an ILOC. There are inherent contractual obligations that an owner must adhere to in order to advance a claim on a performance bond, and the owner also has the ability to prejudice his position to claim under a bond by materially changing the construction contract. 

Construction owners may choose to maintain ongoing communication with the surety (for example, completing contract status reports issued by the surety) in an effort to help avoid potential conflicts. It should be noted that any change in exposure for the surety may result in additional or return premium.

Parental/corporate guarantees

When entering into a construction contract with a contractor that has a corporate structure with substantive financial backing, an owner can request a corporate guarantee from the parent company or another company to backstop contract performance obligations. Any owner that is considering using a guarantee as security should consult with its legal counsel and counterparty risk department as there can be issues in relation to validity and enforceability.

Guarantees can vary in form and style with inclusion of different terms and conditions. Some may be written with restrictive or onerous covenants compared to others. Additionally, guarantees can be written to incorporate a specific liability cap while others are more of a blanket guarantee. A guarantee is only as good as the guarantor providing it, so owners need to have their counterparty risk groups conduct due diligence into the creditworthiness of the guarantor.

An owner should also consider if the guarantor has proper power and authority to provide the guarantee. Some entities (due to application of laws in other jurisdictions or for other reasons) may have limited ability to provide guarantees, and enforcement of guarantees in other countries may be restricted in some circumstances.

Generally, owners will not limit themselves to only one type of instrument to protect themselves from contractor default on large projects. Often, their counterparty risk teams may find uses for all three forms listed above depending on the structure of each specific construction contract.