Should Contractors Get Security from Principals?

Contract Administration

In the construction industry, typically provision of security flows upstream – that is, the subcontractor gives security to the head contractor who gives security to the principal.

The principal, after all, has a legitimate interest in and concern about potential defects during the liability period, and wants to ensure it has some comfort about that. In turn, the contractor keeps retention from the sub-contractor, and in doing so protects themselves to an extent.

But what about the other causes of catastrophic failure, such as the principal going under or refusing to pay outstanding sums? These tend to be a common catalyst for extreme financial pain for everyone else on the project.

A Practical Example

Let’s say that XYZ Contractors Pty Ltd has spent the majority of its business life working for large, well funded and known principals. As a result, XYZ Contractors has never really had to be concerned about the collection risk of their client potentially lacking funds to complete a project.

However, with a tightening market XYZ Contractors is looking at some projects with less well known principals, and in some cases entirely new players in the industry.

An opportunity has arisen for XYZ Contractors to build a multi-story residential development for private investors. The investors have formed a new company as a special purpose vehicle for the development, and funding is being obtained from a variety of overseas sources.

XYZ Contractors is concerned about the principal’s lack of assets, history and experience in development. It is also concerned about the involvement of an unknown financier.

To try and limit its downside exposure, XYZ Contractors could reasonably look at whether it might be able to take a fully or partly secured position before signing on to the project. But how would that work, and what are the options?

The Obvious Barrier to Upstream Security

There is a clear impediment to getting security from a principal on every job – some, perhaps many, simply won’t agree to it under any circumstances.

More often than not, security flows in the other direction – the contractor is required to pay, give or allow retention of amounts to form the security for potential defects and breaches.

That is simply the commercial reality of the world right now.

So as a business, construction companies need to ensure that the risk they are taking on in those circumstances is appropriately compensated or managed along the way. We have discussed some ways to triage business opportunities in our article here.

One example when it comes to security is this: who is your principal? If the principal is a special purpose $2 company with no assets in this country or reputation to defend, then you might need to look at security to cover your fees. Similarly if your job is being performed for a body corporate that does not often engage in construction, then again you could legitimately consider requesting some kind of protection before engaging in the work if you had any doubts about their capacity to pay.

So let’s say you have found a principal who will consider offering some kind of security. What might you request, and which is best?

Types of Security and Their Pros and Cons

Here are the main options that might be available under the guise of “security” when it comes to construction contracts.

Bank Guarantees

Bank guarantees are a binding, documented promise by a financial institution to pay you up to a certain sum, on request and without question.

A bank guarantee differs in substance and value from the rest of the forms of security we’re going to discuss.

There are two reasons:

  1. The source of the security’s value is disconnected entirely from the principal. Provided the bank guarantee is given by a reputable financial institution, the risks that it will not be honoured are extremely low; and
  2. It is essentially unaffected by higher ranking securities.

The result is that a bank guarantee is (outside cash) one of the best forms of security you can get.

Personal Guarantees

This may or may not be a form of security in the strict sense, but it will give you the ability to enforce your rights against a third party – in this case, a director of the company for whom you are performing the work.

Typically this kind of security requires the third party to honour the obligations of the primary company, and allows you to call on them to meet debts or obligations.

In financial terms, however, there is often a question mark of its value – does the individual have any assets of worth? Does the security extend to those assets? Does a financier hold a higher ranking security that would essentially make yours worthless?

Of course you might decide that a personal guarantee is still worth it even if you cannot answer those questions. Many people (not all) are averse to going bankrupt for obvious reasons, and the ability to bring personal proceedings against something at least offers some clout in negotiations even if it doesn’t offer you the financial benefit you might prefer.

Parent Company Guarantees

Where a principal is structured in a way that it is owned entirely by another company, that company is often where the money comes from.

The problem is that your contract is not with the parent company – so if they decide to simply stop paying the bills, then you can’t go straight to the source to get paid unless you have a guarantee from them.

Other than the parties and the reasoning, the parent company guarantee works much in the same way as a personal guarantee.

Real Property Security

Typically if there is a construction project happening, then it’s happening on a piece of land.

If that land is owned by the Principal, then with it comes the opportunity to try and protect your interests by taking some kind of interest in the land.

More often than not, this will take the form of a clause in the contract that secures the obligations of the principal against their “right, title and interest” in the land in question.

While that’s better than nothing, there are two problems with this approach:

  1. You can’t register a construction contract on the property – at best, you could lodge a caveat over the property to prevent its sale, and then commence Court proceedings to protect your interests;
  2. The financial institutes funding the project will almost certainly have a first ranking security interest. As often as not, the amount of that funding will be a significant percentage of the overall value of the land, especially if a half-built construction project is sitting on it at the time and it’s not capable of immediate sale.

Of course you could solve problem 1 by asking for a mortgage in registerable form, though you will face some resistance to this idea.

Problem 2 is harder to solve. For the project to proceed (and your payments to keep flowing) the first ranking financier obviously needs to be protected or they simply won’t lend the principal the money to keep the project going. In theory you could ask for a priority over that financier, but in practice you won’t get it.

One way to deal with this could be to ask for security over third party property (eg the director or head company, as part of a guarantee like those discussed above), since that is not part of the project and may be less heavily encumbered by finance. Again though, you will face some resistance to this and would need to put forward a strong case to convince someone to agree to it.

So a real property security can be an excellent form of security to take if you can get it, but its worth really depends on the finance situation of the project and the property.

Personal Property Security

Taking some form of security over other types of property is another option that might be available.

For many developments, the principal is a special purpose company with limited assets outside the land (and sometimes not even that), so the more likely direction to look would be related companies, ultimate holding companies and directors for this kind of security.

For non-land property, you will need to ensure that your security is registered on the Personal Property Securities Register to maximise its value.

Otherwise, however, it faces roughly the same challenges and risks as real property. That is, check the current value and existing securities against the property before assuming that it has any real value or protection.

Insurance Bonds

Though they are very similar in concept, we need to distinguish bank guarantees from insurance bonds.

Insurance bonds theoretically work the same way: a third party promises to pay you an amount of money on presentation of the bond.

In practice the risk profile is quite different though.

Sometimes the insurance bond will be from a company you have never heard of, or about which information is hard to come by.

Beyond that, to claim on an insurance bond you will probably need to bring the original bond document to the relevant company’s office, so it’s important to check where that is and whether it is feasible to embark on such a claim.

So yes, in theory a bond sounds like an adequate substitute for a bank guarantee, but in practice the details can sometimes make them significantly less comforting when it comes to security.

Just Take what you can Get?

It’s probably true that some security is better than no security, especially in a commercial situation where getting security at all is quite difficult.

However, the cost and time associated with documenting any form of security can be wasted if there is no real value in what you have agreed to.

If you are a contractor in a position where security will “make or break” your desire to take on a job, then make sure you go through the right process to determine whether the security actually gives you anything or not.

Otherwise if things go wrong, you may find things were far less secure than you thought.

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