EMERGENCE OF SURETY BONDS AN ALTERNATE TO BANK GUARANTEES IN INDIA
Surety bonds are an agreement among three parties, the surety company, the contractor or principal and the project owner or obligee. The project owner may be a private business or an public entity such as government or corporation.
The surety provider assures the project owner that the contractor will perform a contract by completing specified work to a specified standard. Terms can also include assuring that the contractor adheres to specific regulations or will pay certain labours, subcontractors and suppliers with the project.
If the contractor fails to perform the work specified, the surety company is responsible to see that the project is completed.
The surety provider offers this assurance bases on its assessment of the contractor, combined with its expertise in both the financial and hands-on aspects of the construction industries. The contractor’s history, capacity, financial strength, character, credit history and a host of other factors are considered before a bond is awarded.
Surety bond is a careful, rigorous and highly professional process. The reason for this diligence is simple. If the contractor fails to meet their obligations, the surety provider must bear the cost of completing the contract. With major project budgets of the company in term of crores, the consequence of poorly made decisions can be disastrous.
In India, SREI CBL Guarantees is joint venture recently established between SREI Group of India and CBL Corporation of New Zealand who will provide such type of surety bonds.
Types of Surety Bonds :
There are three basic types of contract surety bonds.
- The bid bond provides financial assurance that a bid has been submitted in good faith, that the contractor intends to enter into the contract at the price bid and that the contractor will provide the required performance bonds, as well as lobour and material bonds.
- The performance bond is the best known surety bond. This bond assures that the contractor will perform the contract as specified. If the contractor fails to meet the obligations of the contract, the surety company will see that the project is completed.
- The labour and materials bond ( payment bond) guarantees that the contractor will pay specific subcontractors, labourers and material supplies associated with the project.
Structure of the Surety Bonds:
Each of the parties has responsibilities related to each other party.
- The principal has the duty to the obligee to perform its contract. The obligee likewise owes a duty to the principal to uphold its end of the contract, including payment in accordance with the contract terms.
- The surety has a duty to the obligee to take action under the terms of the bond if the principal defaults under the contract. But the obligee has a duty to fulfil its bargain under the contract, again, including payment of any sums due under the contract, but this time to surety that performs.
- The surety and the principal also have duties to each other. The surety has the duty to determine whether the principal is in default and abide by the terms of the bond and any agreement of indemnity. The principal must co-operate with any investigation of an allegation of default and reimburse the surety for any losses incurred due to the default of the principal on its promise.
Few key benefits of this Suerty Bonds are as under.
- An option and an alternate to Bank Guarantees.
- Don’t require margin / cash collateral or liquid assets which frees up working capital saving the client money, strengthening their ability to complete projects and giving them options to grow and develop their business.
- With more working capital back in the hands of the contractors and projects being completed on time will enhance government’s effort backed by the security of the sureties and guarantees.
Redemption and claim process:
When a claim is made on a bond, the surety must investigate the allegation of contractor default. The principal must co-operate with the surety and provide the information necessary for the surety to make a decision of whether it must perform under the bond. For example, the surety will examine the validity of the bond, whether notice of default was proper, whether there were material alterations or changes in the scope of the contract or gross overpayments, among other information.
If the surety determines that its obligations have not become void, the surety will identify its course of action, which may include as under.
- Providing financial or technical assistance to the contractor
- Arranging for replacing of the contractor.
- Re-building the project for completion
- Paying the penal sum of the bond.
Difference between Surety Bond and a Bank Guarantee
|
Surety Bonds |
Bank Guarantees |
| Document Format | |
| A contract surety bond is a three-part agreement where the surety guarantees to the project owner that the contractor will perform the contract in accordance with the contract documents. | A bank guarantee may take the form of a performance bond or a form of letter of credit. |
| A performance bond protects the owner from nonperformance and financial exposures should the contractor default on the contract. It is directly tied to the underlying contract and if the contractor is unable to perform the contract, the surety has responsibilities to the owner and contractor for project completion. | Banks generally issue bank guarantees which take form of a performance bond include a clause to pay when the bank guarantee is invoked by ghe beneficiary. |
| Security | |
| With few exceptions, performance and payment bonds are issued on an unsecured basis. That is, they are usually provided on the construction company’s financial strength and experience and contractor’s indemnity and personal guarantees from the contractor’s owners. | A bank will almost invariably require an indemnity from the contractor, personal guarantees from the owners of the contractor, and the tagible security from whoever is able to supply it. |
| The issuing of the bonds has no effect on the contractor’s bank lines of credit and in some instances, can be viewed as a credit enhancement. Unused borrowing capacity can be viewed as an off-balance sheet strength. | Specific assets are pledged to secure Bank Guarantee. Bank Guarantees reduce existing lines of credit. |
| Cost | |
| The cost of a bond varies from 1% to 3% per year, and is calculated on the face value of the bond. Once paid the premium is fixed. | The bank fees are payable at 3 or 6 month intervals and may be payable on the facility amount as opposed to the amounts actually issued. |
| The premium is payable up in one lump sum absent any arrangements with surety. | Other administration fees may be payable. Overall cost, direct and indirect is hard to assess given that hard assets are tied up with a bonding facility. |
| Claims | |
| Depending on the bond format the surety company will have a number of alternatives in the event of a call, or a threatened call, under a bond.
They are: Finance the original contractor or provide support necessary to allow it to finish the project; Arrange for a new contracted to complete the project; Assume the role of the contractor and subcontract out the remaining work to be completed; or Pay the amount of the bond |
While banks have the same alternatives as mentioned alongside, the reality is that given that banks will be holding security, and given also that their expertise lies in areas other than that mediating in contracting disputes, banks will be inclined to pay out and look to the contractor for re-reimbursement. |
Benefits of Surety Bonds to each party in the Transaction :
Once a contractor is known to a surety provider, it becomes much easier to evaluate projects and issue appropriate bonds. Many successful contractors view their brokers and bonding companies as important business partners, involving them in the bid decision and development process.
Benefits to Project Owners:
For those instigating a project, bonding ensures that all bidders are capable, competent and serious. Unqualified or irresponsible bidders are eliminated.
Project owners can be confident that the contractors they select have the necessary skills and resources to complete work on budget and to be specified standards. In the rare cases where unforeseen circumstances create problems, the surety company will provide the resources to complete the work.
Bonding can assure that specific standards are met and that appropriate payments to subcontractors and suppliers will be made. This virtually eliminates the filing of liens, making the transfer on completion a far smoother process.
Benefits to Contractors
Obtaining a bond tells that a business is successful, well managed and reliable. Bonds are commonly required to bid on substantial contracts. Even when a bond is not mandatory, the security a bond provides can be a distinct competitive advantage.
In the course of the pre-qualification examination of a company, it is not uncommon for the surety company to make suggestions for internal changes that will make the contractor easier to bond. These changes usually lead to operational improvements, more efficient management or both. The end result can be more profitable, competitive business for the contractor.
Ancillary Benefits to Banking in the country
We all are aware of the bad debt problem of the Indian Banking System. A sizable chunk of the NPAs that the banking system is presently saddled with has originated from the infrastructure sector. Analysis of the nature of the problem reveals that many of the project contractors had placed unrealistic low bids to win projects and eventually many of those ran into financial problems and ultimately those projects came to a standstill. The banks which took exposure in such projects suffered in the process. Now, this is one problem which can be bypassed if we have a vibrant market for Bid Bonds in India. In developed nations like USA, Canada, Germany, a Bid Bond or Surety or Performance Guarantee is a part of pre-qualification criteria for bidders, especially for government sponsored infrastructure projects. In India, the market for such instruments has not yet developed. As of now, only banks provide such instruments in India and there is an urgent requirement to develop such Surety Bonds and offerings here. We need to expand the market for such instruments by bringing in more issuers. This will help to:
- Mitigate the high construction risk which, in turn, can bring down the lending rate.
- Curb contractors’ tendency to submit ultra-low or frivolous bids for the sake of winning tenders as such projects have higher chance of running into trouble later.
Way forward:
With increasing regulatory burden placed on banks, coupled with their enhanced risk aversion since global financial crisis, Sureties are gradually becoming a popular alternative. This is even more evident in geographies witnessing growth in construction activities where previously 80-90 % of the requirement was supported by letters of credit issued by banks. While there is a clear need for adopting sureties as an alternative to bank guarantees, the growth in its usage has to be preceded by changes in the regulations determining the scope & acceptance of the product, the role of various market participants and the judiciary.
An instrument like this is an imperative for a nation like ours where there will be large scale construction in infrastructure and real estate sector in the coming years.
Author
Janardan Gadi
Faculty, Chief Manager (Technical)
Union Bank of India, Staff College,Bengaluru
Published : Banking Finance, March – 2019