BRAD BOERTJE: Construction guarantees offer the sector compelling risk mitigation

In today’s tough economic climate, contractors and subcontractors need to pay careful attention to their cash flows, or risk losing money even when they have secured and completed a contract. One area in which a bit of homework would pay significant dividends is the issue of security.

Broadly speaking, security can be defined as either a financial instrument or cash used to provide protection against default by any party across the value chain. In construction, contractors and subcontractors are usually asked to provide security against non-performance. Across most of the industry, clients and main contractors tend to use cash retention for this purpose, which broadly means that 10% of any payment due to a contractor is retained by the main contractor or the client to protect them against subsequent non-performance.

There are a number of important caveats to consider. First, contractors seldom ask for, and are usually not given, security against payment — though some of the larger employers do provide such security. The result is that the subcontractor remains at risk of nonpayment by the main contractor, which is in turn at risk of nonpayment by the employer. Conversely, the contractor has probably given the employer a performance guarantee, and has also received one from the subcontractor.

In other words, the risk is not evenly balanced; contractors are at risk of nonpayment, while the employer enjoys the benefit of a performance guarantee.

Second, if the Joint Building Committee Contracts (JBCC) or Master Builders SA (MBSA) contracts are followed to the letter, the subcontractor would only receive payment once the amount retained exceeds the 10% of the contract or subcontract price. In practice, the parties usually follow the practice of simply deducting 10% from each payment as it becomes due, but a main contractor or client would be within their rights to demand that the full 10% is built up first. Needless to say, the result would be a devastating cash crunch for the entity providing the security.

Free cash, delayed profits

Another downside is that the subcontractor is essentially ceding its hard-won cash to somebody else free, as cash retentions never attract interest. It’s worth bearing in mind that with margins being so low at present, the potential profit on the contract might very well be less than the retention. With the profit only being realised at the end of the project, to put it bluntly, the subcontractor will have a negative cash flow for the entire duration of the project. Not many could survive that!

There’s another risk attached to cash retentions: if the main contractor or client (that is, the entity retaining the cash) goes into liquidation or business rescue, the subcontractor simply becomes an ordinary creditor with little or no chance of seeing even a fraction of their cash. In today’s economic climate, this is a very real scenario.

There is an alternative, and that is a guarantee from an insurance company. JBCC and MBSA construction guarantees can be either variable reducing guarantees or fixed guarantees combined with cash retention.

The variable reducing guarantee is initially equal to 10% of the contract or subcontract. It reduces to 6% when more than 50% of the contract sum is certified in an interim payment certificate.

The variable guarantee will reduce further to 4% when the project reaches practical completion, and 2% when it reaches final completion. The final amount is only paid once the final payment certificate is issued (not when final completion is achieved).

This structure has been consistently used in JBCC and MBSA contracts since 2007. Alternatively, a fixed guarantee can be used in conjunction with cash retention. In this case, the cash retention reduces to 5% of the contract sum.

Using a guarantee makes more sense because it preserves the subcontractor’s cash and reduces exposure to contingent risks such as the main contractor going into liquidation or business rescue.

However, those who take out a guarantee should bear the following two points in mind: it is much better to take out a guarantee with an insurer — banks typically require 100% collateral whereas a reputable insurer would require in the region of 30%. And make sure to include the cost of the guarantee in your initial quote.

One can never eliminate risk, but rethinking how you do things can help reduce it substantially.

• Boertje is a construction risk management consultant and ADR practitioner for the Master Builders Association North.