A bank guarantee is a type of collateral in which the bank guarantees the fulfilment of an obligation by its client, i.e. the guarantee applicant, and assumes the obligation to pay if the guarantee applicant does not fulfil its contractual obligations to the guarantee beneficiary. The main purpose of issuing a bank guarantee is to provide security to the guarantee beneficiary, i.e. to regulate the relations between the parties if the obligations are not performed as stipulated by the Construction Contract.
It is interesting to note that the bank guarantee first appeared in the 1960s, specifically as a collateral for securing Construction Contracts when construction works of high value were contracted. However, today, the application of the bank guarantee is extremely wide, both in domestic and international trade. When it comes to higher value transactions, a bank guarantee will be the most common type of collateral.
Construction Contract is a type of services contract by which the contractor obliges to perform specified construction works or construct a building in accordance with a specific project, within the agreed time, while the employer undertakes to pay him a certain price. Construction Contract is one of the most complex contracts due to its economic value, the fact that the execution of construction works usually takes a longer period of time, as well as due to the complexity of the contracted works. Precisely because of these characteristics, this contract generates a high risk for both the contractor and the employer, given that in case of non-performance of the obligation of the other party, each of the parties may suffer significant damage.
The risk of the contractor is reflected in the possibility of the employer failing to fulfil its obligation, i.e. failing to pay the agreed price after the completion of the works. On the other hand, the employer is exposed to the risk of the contractor not performing the works at all or not performing them in accordance with the regulations, standards of the construction profession or the contract. These circumstances encourage the parties, when signing the contract, to envision various types of collateral in order to protect their interests as much as possible, while anticipating the amount of potential damage they would suffer in case the other party fails to fulfil the contractual obligations.
Statutory and contractual liability of a contractor
Legislators have also recognized the above stated characteristics of Construction Contracts as well as the public interest which permeates construction as a business activity, hence they prescribe special rules regarding the liability of contractors. Accordingly, Law on Obligations provides special provisions relating to the liability of the contractor. Besides the fact that the rules on defects of the work provided for the Services Contract are correspondingly applied to the defects of the construction, the Law on Obligations particularly regulates the liability of the contractor for the solidity of the building within 10 years from submission and acceptance of works.
However, the provisions of the Law on Obligations do not always provide satisfactory security to the employers, which is why they regularly require contractors to provide them with additional collateral. When it comes to the performance of construction works of higher value, the parties most often opt for a bank guarantee as a collateral, especially when it comes to securing an advance payment (where the employer is more exposed as, at the moment of payment, he receives no counteraction or benefit).
In some cases, parties will prefer to arrange a bill of exchange as a collateral, given that the issuance of a bill of exchange is more suitable when the value of contracted works is not high, because in that case it is not economically justified to require the contractor to pay a high fee for the issuance of a bank guarantee.
Types of collaterals issued for securing a Construction Contract
Depending on the risk that the employer is trying to secure, there are the following types of guarantees:
- Advance payment guarantee;
- Performance guarantee; and
- Defect liability guarantee.
These three types of bank guarantees are most often contracted because they represent security against the risks to which the employers are most exposed, i.e. for which it has been shown that they are most often realized. Regularly, these guarantees are issued as unconditional and irrevocable first demand guarantees.
The employer may request to determine the credit rating of the bank that will issue the bank guarantee under the contract (typically, a credit rating corresponding to at least the level 3 of credit quality is required) or to choose a bank he finds acceptable. It is common for such guarantees to be issued as non-transferable, meaning that the transfer of these bank guarantees requires the consent of the parties and the issuing bank.
Advance payment guarantee
Advance payment guarantee is a bank guarantee by which the bank undertakes to pay a certain amount of money to the guarantee beneficiary, i.e. the employer, in case that the guarantee applicant, i.e. the contractor, does not fulfil the contractual obligation for which he received the advance payment. If the Construction Contract stipulates the obligation of the employer to pay a certain amount to the contractor before the commencement of the works, as an advance payment, the employer will usually want to secure such amount. This type of bank guarantee allows the employer to refund the advance payment in full in the event that the contractor does not fulfil its obligation at all, when he does not fulfil it satisfactorily, as well as when the advance payment is not used for a purpose specified by the Construction Contract.
The advance payment guarantee is usually granted for the amount of the agreed advance, but it can also be for a smaller amount. The employer will usually require that the period of validity of this guarantee be at least equal to the period specified for the performance of the agreement, i.e. until the final settlement of accounts.
Performance guarantee
By issuing a performance guarantee, the bank undertakes to pay a certain amount to the guarantee beneficiary, i.e. to the employer, if the contractor does not fulfil or improperly fulfils its contractual obligations. The guarantee amount can be determined in several ways, as follows:
- a fixed amount;
- a certain percentage (usually 5% or 10%) of the contracted value of works; or
- by determining the upper limit or maximum amount that the bank will be obliged to pay.
The shortest period of validity agreed for a performance guarantee is until the expiry of the time for the completion of contractual obligations i.e. performance of construction works, but it is often agreed that it is valid until the expiry of a certain period after this (e.g. the guarantee is valid for 30 days after the expiry of the deadline for the completion of construction) or it can be agreed that this guarantee is valid until the contractor issues a defect liability guarantee.
Defect liability guarantee
Defect liability guarantee is a type of bank guarantee by which the bank undertakes to the guarantee beneficiary, i.e. the employer, to pay possible claims if the performed works have defects that the contractor fails not eliminate at the request of the employer. Depending on the intentions of the parties and the value of the performed works, the guarantee period can last from 12 months up to 10 years. If the agreement stipulates mandatory issuance of a defect liability guarantee, and the contractor does not provide this guarantee, the employer has the right to collect a performance guarantee. Namely, these two types of bank guarantees are linked because it is usually agreed that the employer returns the performance guarantee to the contractor only after the contractor submits a defect liability guarantee during the guarantee period.
The guarantee amount is usually agreed in a certain percentage (typically 5% or 10%) of the agreed value of the works.
Conclusion
Having in mind the above, bank guarantee is always one of the most desirable and safest collaterals for the employer. Bank guarantees enable the employer a quick, easy and safe collection when the contractor does not fulfil the obligations he undertook under the Construction Contract. On the other hand, for the contractor, bank guarantees are an expensive collateral because of the price he has to pay to the issuing bank, which amounts to about 2-3% of the approved amount of the guarantee on an annual basis. However, for employers, no bank guarantee is a deal breaker when it comes to contracting performance of high value works.
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