Why do contracts include provision for financial and performance guarantees? What are they and what benefits do they offer?
Have you ever felt confused about the financial and performance guarantee clauses in Commonwealth contracts? You are not alone. While these clauses are almost boilerplate in Commonwealth contracts, many people don’t really understand them.
No longer will you need to go and secretly google the meanings on your phone when you think no-one is watching - we have some simple explanations in this article!
As with our previous article on precedence we are quite nerdy about these clauses too.
In a nutshell:
- Financial guarantee reduces risk by allowing the customer (you/the Commonwealth) to withdraw money from guarantor bank in the event that contractor is in breach of the contract.
- Performance guarantee reduces the customer’s risk by allowing for performance by an alternative entity if the contractor fails to perform.
Both of these guarantees are collectively referred to as the ‘guarantees’ in this article. They are explained in more detail later.
The Commonwealth usually requires guarantees if the risk assessment shows that the contractor represents a level of risk that requires some back-up protections (in addition to those already included in the contract).
Guarantees can offer very useful risk protections for contracts if, for example:
- You are dealing with an entity without substantial experience in the work being contracted to them
- You are paying quite a lot of the overall charges for the contract before receiving the final deliverable
- You are dealing with an entity that is part of a larger group of companies and want some assurance from the holding or parent company
- Your risk assessment otherwise tells you that it is important to use these sorts of contractual tools to motivate performance by the contractor.
Here’s a short plain English guide to these contract mechanisms.
A financial guarantee provides a guarantee to the customer that if any of the events covered by the guarantee happen, the guarantor will pay out funds to compensate the beneficiary of the guarantee (usually the customer). This form of guarantee is usually given by a bank and is commonly referred to as a ‘bank guarantee’ or an ‘unconditional financial undertaking’.
The contract clause will usually oblige the contractor to provide a financial guarantee from an organisation acceptable to the customer (you), using a template form of guarantee that is attached to the contract.
If such a guarantee is required, the contractor will obtain a guarantee from its bank.
The bank will agree to provide a guarantee if it accepts the risk of the arrangement, and subject to payment of a fee by the contractor (which might be a percentage of the guarantee value).
The contractor will usually seek to pass the cost of the guarantee onto the customer either by including it in the contract charges, or by charging that amount separately to the customer.
The template financial guarantee will commonly provide that:
- The guarantor agrees to pay an amount up to a specified cap to the customer if the customer makes a claim on the guarantor
- The customer can make a claim if the contractor is in breach of contract
- The guarantee is unconditional – this means that the customer does not have to prove that the contractor is in breach of contract. However, if the customer makes a claim and there is in fact no breach of contract, there is a risk that the contractor will claim that money back. This is because if the guarantor has to pay out under the guarantee, it will usually seek to reclaim that amount from its customer (i.e. the contractor)
- The guarantee continues for a defined period of time (e.g. the term of the contract including any extensions or until the full amount is paid out, whichever is earlier).
The courts have recently confirmed that an unconditional guarantee can be claimed on without any burden of proof.
The recent Tasmanian Supreme Court case of Hansen Yunken Pty Ltd v Parliament Square Hobart Landowner Pty Ltd provides guidance on the right of recourse to a bank guarantee. In this case a dispute arose regarding a landowner’s entitlement to a defects bond from builders contracted for a major construction project, Hansen Yunken Pty Ltd. The defects bond was an unconditional bank guarantee, which was held by Parliament Square Hobart Landowner Pty Ltd.
The Court held that this guarantee was “an unconditional and irrevocable promise by the relevant bank to pay on demand any sum demanded” by the landowners and that an unconditional guarantee was comparable to a cash bond. It was found that in cases where an unconditional guarantee fulfils the function risk allocation in a contract (and is facilitated by an undertaking on part of the third party), the court will not prevent access to the funds if there is a dispute on foot except in cases of fraud, or in order to prevent unconscionable conduct on part of the benefiting party.
A performance guarantee is a guarantee given by the contractor’s parent or related company (guarantor) which can be used if the contractor fails to perform its undertakings under the contract (and the guarantor will then be required to perform those undertakings).
The contract clause will usually oblige the guarantor to provide a performance guarantee and indemnity in the form of a template guarantee that is attached to the contract.
The template form of guarantee will commonly provide that:
- If the contractor fails to execute and perform its undertakings under the contract (between the contractor and the customer) then the guarantor must do so in accordance with the contract. If the contract is then terminated for default, the guarantor must indemnify the customer against costs and expenses directly incurred by reason of such default
- The guarantor will not be discharged, released or excused from the performance guarantee by an arrangement made between the contractor and the customer with or without the consent of the guarantor, or by any alteration, amendment or variation in the obligations assumed by the contractor
- The performance guarantee will continue in force and effect until completion of all the contractor's obligations under the contract or until the completion of the undertakings in the performance guarantee.
What can you do from a practical perspective when considering the contractor’s position on the above?
You have now probably worked out that contractors will often resist the inclusion of the financial undertakings and/or performance guarantees.
Whether to accept this will be a commercial and risk management decision for the customer. In your risk assessment you should consider and weigh up the financial viability of the contractor and overall risk profile of the contract. You may be able to negotiate improved commercial terms in return for reducing or removing the guarantee obligations.
If you require the guarantees, make sure you obtain them before any work commences, and ideally before the contract is executed!
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