Types of security

Security may be provided by way of cash, bank guarantees, insurance bonds or parent company guarantees.

Cash retention

Cash security is typically held by the principal by deducting a retention from each progress payments due to the contractor. The amount withheld is usually a fixed percentage of the amount payable under each progress payment up to a certain cap as agreed between the parties under the construction contract.

It is helpful to have the construction contract specifically state whether retention is held by the principal on trust for the contractor and also whether or not the principal will pay interest on retention money.

Whether retention has become the property of the contractor but held on trust by the principal, is a matter of contract interpretation.

Bank guarantees and insurance bonds

Both bank guarantees and insurance bonds contain a promise by a third party to pay a specified sum of money to a named beneficiary when a specified event occurs. Often the ‘specified event’ is nothing more than a demand for payment.

A bank guarantee is not a guarantee in the true sense but only a promise to pay an amount, typically unconditionally and on demand.

In order to obtain a bank guarantee, the contractor will have to pay a fee to the bank and may be required to provide other security to the bank as collateral such as a cash deposit or a property mortgage. It is similar to the contractor obtaining a loan facility from the bank.

Contractors generally prefer providing bank guarantees as opposed to retention money as security to minimise impacts on their cash flow and financial ability to ensure that their subcontractors, employees, suppliers and other contractors on a project are paid.

Insurance bonds are undertakings provided by insurance companies. Usually the contractor does not provide the insurer with security. The insurer will instead charge the contractor a fee that is assessed having regard to the risk of the insurance bond being called.

Parent company guarantees

If the contractor is not a substantial company or a subsidiary of another company (‘parent company’), the principal may require a  guarantee from the parent company.

A parent company guarantee is typically a promise by the parent company to stand behind the contractor and to be responsible for the contractor’s default of its contractual obligations. Alternatively, it may be limited to an obligation to step in and perform the contractor’s obligations. In either case, the parent company’s liability may be capped.

Letters of comfort

Occasionally (particularly where the contractor is not Australian), the contractor will offer a letter of comfort from its parent company or a financial institution as security. The letter is usually not a guarantee or undertaking, but rather a statement of support or confirmation of standing in relation to the contractor.

Letters of comfort should be treated with great care. It can often be unclear whether they create enforceable legal rights. For example, if they are inaccurate or misleading, the recipient of a letter of comfort may have rights under section 18 of the Australian Consumer Law. Even though letters of comfort fall outside a classic contractual framework, they may amount to representations upon which reliance may be placed.