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Commercial Question

Safely constructed

updated on 06 October 2009

Question

How are the positions of construction industry clients, contractors and subcontractors secured?

Answer

Security and security documentation is a highly topical issue for construction lawyers. Clients, contractors and subcontractors have competing interests that must be met. Clients are seeking to minimise the impact on them, should contractors or consultants become insolvent; contractors are seeking security from clients to ensure that they get paid, and trying to cushion the impact of a subcontractor's potential insolvency; and subcontractors want to ensure that their contractor pays them. There are various ways of achieving these aims.

Parent company guarantees

A parent company guarantee is where a company entering into a contract (the subcontractor) is required by its client to provide a guarantee of its performance from its parent company (the contractor). A parent company guarantee is only as good as the covenant strength of the company providing it. Therefore, it is important to check the financial standing of the parent company and to make sure that it not only has capacity to enter into the guarantee, but also stands to gain a commercial benefit from doing so. The guarantee must also be made in writing, in order to comply with the Statute of Frauds 1677.

The guarantee itself should include a clear statement about what the guarantor is guaranteeing and on what basis (primary or secondary liability), along with a provision that the guarantor will pay the losses suffered if the contractor/employer breaches its obligations or becomes insolvent. In the case of a guarantee of a contractor's obligations (as opposed to a subcontractor's), a provision can also be included that compels the guarantor to step into the contractor's shoes and finish the development or to ask another subsidiary (if there is one) to do so. As changes to the underlying contract can release guarantors from their obligations, the guarantee should contain provisions setting out that this will not happen.

Bonds

Bonds are offered by either bondsmen or banks in return for a premium. They come in two forms: on demand or default (otherwise known as performance bonds). In the UK construction market, bonds that relate to a contractor's performance are generally default/performance bonds. They are usually for 10% of the value of the works and unlike parent company guarantees (which generally last for the duration of the guaranteed company's contractual liability), they last until the works have been completed. If the contractor or employer is in default, the other party can claim on the bond and use the money to offset the additional costs incurred.

On-demand bonds are more akin to a letter of credit than a guarantee. In the United Kingdom, they are generally used not to guarantee performance, but rather when:

  • an advance payment has been made by an employer;
  • an employer has agreed not to withhold a retention; or
  • the employer has agreed to pay for materials which are not stored on site.

Retention

Most building contracts include provisions that allow clients to withhold an agreed sum of money from payments made to contractors during the build period - usually between 3% and 5%. If a contractor becomes insolvent or breaches the contract, the employer may be able to use its own money to offset the additional costs it may incur as a result. Similar provisions are included in subcontracts, which allow contractors to do the same with their subcontractors, providing the contractors with an additional element of security in respect of the subcontractors' work.

Escrow accounts

If a contractor is concerned about a client's ability to pay, the contractor may request an escrow account. The client deposits an amount equivalent to all or part of the contract sum (the price of the works) with a third party (ie, a firm of solicitors). The client and contractor sign an escrow agreement, which will include the basis on which the contractor can call for money from the account and the basis on which it is held. It will also state whether the account will be topped up if a call is made and which party is entitled to the interest on the money.

Project bank accounts

These have become more common following endorsement by the Office of Government Commerce in its Guide to Best 'Fair Payment' practices (a document recommending the best fair payment principles and practices for adoption in the public sector). A bank account is set up by the contractor and the client. When money is due to be paid under the building contract, the client pays the relevant amount into the bank account. The bank then pays the amount to the contractor and the relevant subcontractors directly. This ensures that subcontractors receive payment promptly, but does not provide payment security for all sums in the way that an escrow account does.

Fiona Bishop is a professional support lawyer in the projects and construction department at Trowers & Hamlin LLP.