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Contractor Default Protection for Industrial Project Owners – Part 2

In Part I, we compared three common instruments used by project owners to protect themselves from contractor default on large, multiyear industrial construction projects.

The risk checklist: a guide to help project owners determine the best solution for contractor default protection

In Part I, we compared three common instruments used by project owners to protect themselves from contractor default on large, multiyear industrial construction projects:

Liquid Security (specifically irrevocable letters of credit- ILOCs)
Surety bonds
Parental/corporate guarantees

Most project owners do not limit themselves to the use of just one instrument. In fact, their counterparty risk teams may use all three, depending on the structure of each specific construction contract. Here is a checklist for owners deciding which instrument to use. As owners make decisions using this model, they must be aware of their own appetite for risk as they assess the risk of each contractor. They should also consult their legal counsel and coordinate with their risk management department and consultants.

1. Dollar amount of instrument

Most owners determine how much security is required from a contractor based on how they rate the contractor’s credit, and the anticipated cost of financing the transition from the defaulting contractor to the replacement contractor. Some owners will give the option of either an ILOC or a low-penalty performance bond of equal value that is small in relation to the contract value (e.g. 10 per cent). Because surety is unsecured credit, other owners will ask contractors to leverage their balance sheets to provide security at larger amounts (generally 50 per cent of the contract value), which can address catastrophic loss from contractor default on a project.

Occasionally, an owner will accept a parental guarantee for a contractor that is not backed by an investment grade rating.

Here, owners might use an established formula and credit-scoring tool to determine the maximum dollar amount of parental guarantee they can accept. If additional security is required, a performance bond or ILOC can be provided to cover the total exposure. Contractors may be working for an owner on multiple projects secured by multiple ILOCs. Most owners are aware that this accumulation of contract security has a direct correlation with the contractor’s working capital. Some owners create a ceiling for ILOC exposure from each contractor so that erosion of working capital cannot degrade the contractor’s financial position to a point where the contractor is unable to finance projects. Once this ceiling is reached, the owner may still engage the contractor on more projects, but will request performance bonds and/or parental guarantees to secure them.

2. Claims protocol

Owners have to determine if they want full discretion to declare default on a contractor and enact a financial instrument as remedy or, as it is with the surety relationship, they are willing to accommodate a third party’s interests during the claims process. Owners have full control of a default claim process with liquid security. Although they must act in good faith, they are able to declare a contractor in default and enact the financial remedy immediately to finance the transition to a replacement contractor. Any recourse from the defaulting contractor is dealt with after the event.

The involvement of a surety during a claim under a bond has the potential to create significant project delays. When an owner and contractor are in dispute the surety might side with the contractor and wait out the arbitration and/or litigation process. This surety would determine their response to the bond claim based on the court’s final judgment. The trickle-down effect of a project delay might be so expensive that the owner cannot afford to wait out the claim process with a surety—it would be more cost effective to remedy the default themselves and continue with the construction schedule, even though this would prejudice the owner’s position under the bond. If the cost of time is a big enough factor for project owners, they might bypass surety as an option.

Every surety company responds to claims with a different approach—some more timely than others. The owner does not control which surety furnishes bonds for each contractor.

3. Pricing

Some owners consider parental guarantees the best option to guarantee construction performance obligations because they cost nothing.

Surety bonds will range in price depending on the contractor’s relationship with their surety. Different surety exposures such as low-penalty bonds, extended contract durations, and extended warranty obligations can create surcharges and discounts in bond rates.

ILOC pricing can also vary significantly depending on how banks rate each contractor as a credit. Owners must make a conscious decision about how much they are willing to pay for protection. The best practice is to have contractors outline the cost of security in their proposals and tenders to avoid surprises later.

4. Contractor prequalification

An owner must decide whether to outsource contractor prequalification to a third party or take it on in-house. Using surety as a remedy for contractor default gives the owner expert and involved contractor prequalification and lessens internal workload. The benefit of surety prequalification is that the surety will have a long-standing relationship with their contractor that has been built on a bank of experience. This analysis goes beyond basic credit review.

5. Level of engagement at tender stage

The owner will negotiate terms with a pre-selected contractor, accept proposals from contractors in answer to a request for proposal (RFP), or establish a formal tender process. If the owner selects the latter, he can request security from all the bidders at the time of tender. This can be either liquid security or surety bonds (bid bonds) that guarantee each contractor will honour the tender price.

Although there is no cost with bid bonds, if contractors are asked to furnish them with their tender package, the expectation is that the successful contractor will also furnish a performance bond to guarantee the contract. At this time, the contractor’s surety will charge premium. The surety industry is not in business to prequalify contractors at the bid stage without realizing premium once the contract is awarded.

Another tool for owners is a “prequalification letter” from a contractor’s surety that can be requested during an RFP process or negotiation with a contractor. This is a non-committal letter that gives a general idea of whether surety support might be available for a specific project. Again there is no cost for this document but there is no guarantee associated with it.

6. Contract language

Use of these three instruments (liquid security, surety bonds, and parental/corporate guarantees) as contract security is generally limited to fixed price contracts, and the value of the instrument is tied to the cost of financing the transition to a new contractor in the event of default. However, some owners might still require some low-penalty collateral from a contractor on a cost-reimbursable contract to ensure they have some leverage with the contractor to avoid default.

When contracts are secured via an ILOC, this extension of credit from the contractor’s bank has no direct correlation to the construction contract itself. The bank issues the ILOC from existing credit facilities. On the other hand, before surety bonds or parental/corporate guarantees are furnished, the surety creditor or corporate guarantor may choose to evaluate the contract wording to determine if there are any onerous clauses (such as extended warranties or efficiency guarantees) that can make the related exposure unpalatable.

Project owners need to be aware that a contractor’s ability to provide requisite performance security may be restricted because of contract wording.

7. Acceptable wordings

All three types of contract security instruments can be worded to improve an owner’s position. An owner should evaluate his parental guarantee wording on an ongoing basis and be aware that “standard” bank ILOC wordings or “standard” surety industry wordings are subject to negotiation and change.

The best advice to owners drafting ILOC, surety bond and parental guarantee wordings to match their appetite for risk is simple: Test the market. For all three types of instruments, each contractor would have to review and accept the proposed wording. For ILOCs and surety bonds, the next step would be to present the wordings to the applicable bank and surety for approval. All of these groups are generally willing to negotiate terms or at least engage in discussion

8. Acceptable creditors/acceptable paper

Owners have to be aware of what paper they deem acceptable as security. When using parental guarantees, the process is easiest because the paper is inherently backstopped by the credit rating of the contractor’s corporate family. However, with ILOCs and performance bonds, the owner should make a point of short-listing banks and surety markets whose paper is rated to meet his appetite for risk.

Many owners will engage in contracts with international contractors. These contracts still require security. Some project owners work with a Canadian bank to act as a fronting creditor for these international contractors. In this situation, the end security product (ILOC) is presented to the owner on acceptable local paper, and it is up to the contractor to structure the deal so that his overseas creditor backstops the arrangement. A similar arrangement could potentially be set up with surety markets that issue domestic paper.

Project owners should be aware that regardless of what type of instrument is chosen to mitigate counterparty construction risk, the determination of default will always go back to the actual construction contract. This is where negotiations must begin. It is important that the legal, procurement, and counterparty risk teams of an owner share a mandate for controlling the volatility of contract default risk, and that ongoing controls are in place to help realize the intended result.

Construction engineers discussion with architects at construction site or building site of highrise building with Surveying for making contour plans is a graphical representation of the lay in land.

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Contractor Default Protection for Industrial Project Owners – Part 2