The construction bond market and alternative security

There have been a record-breaking number of construction insolvencies in the UK over the past twelve months – in March 2023 alone, 38 construction companies entered into administration. In the last two months we have seen two high profile insolvencies: Henry Construction and Buckingham Group (two large contractors turning over £402m and £665m respectively), have entered into administration.

But will these insolvencies have a detrimental effect on the bond market? The answer is yes – these insolvencies are large insured exposures for the surety market and, as a result, it has taken a blow. Bond providers are now seeking to manage risk by tightening bond capacity. Brokers and bond providers are warning contractors that it will now be significantly more difficult to obtain bonds in light of the high-profile insolvencies we have seen this year and, further, if contractors are able to obtain bonds, it is likely they will be paying a hefty premium.

Surety in the construction industry is an important tool to provide protection to all parties involved in a construction project. But if providers are tightening bond capacity, and contractors cannot procure bonds, how else can parties get this protection? We have considered three alternative forms of security commonly used in construction projects.

Parent Company Guarantee

A parent company guarantee (PCG) is granted by the parent (or holding) company of a party to guarantee the performance of the subsidiary company’s contractual obligations.

A true PCG can only ever be a secondary obligation (and not a primary obligation). The significance of this is that a true PCG can only be triggered in the event the contracting party defaults on its obligations under the contract. However, parent companies should ensure the document that outlines the PCG clearly states the parent is only liable in the event of a default by the subsidiary company. Otherwise, the PCG may actually be an indemnity and confer a primary obligation on the parent company – a far greater undertaking because an indemnity is independent of the underlying contract and will be valid even if the underlying transaction is set aside – a guarantee will not.

Further, in order for a true PCG to be enforceable it must be in writing (and if you are as boring as I am then you will know this is a requirement of section 4 of the Statute of Frauds Act 1677). However, unlike guarantees, indemnities can be made verbally.

Most commonly, PCG’s are granted in favour of the developer of a construction project to guarantee the performance of the main contractor, although in theory they can be offered by any parent or linked company and in respect of any contract (e.g. a contractor could require a PCG from a key sub-contractor). It is important to make sure that the company giving security is itself of good standing though, otherwise the security may end up being worthless.

Escrow Agreements

The purpose of an escrow is usually to provide a fund which the contractor can draw in the event of the employer defaulting on payment. Often, in construction projects, escrows are used when the employer’s solvency is not certain (such as when the employer is a special purpose vehicle incorporated specifically for the project in question). However, recently we have seen a number of escrows used in a different way. For example, we acted for a main contractor who was required to enter into an escrow agreement as it was unable to obtain a bond.

The way escrows work is simple – a pot of money is paid into an interest-bearing bank account. The escrow account that holds the money is held by an escrow agent, typically a solicitor or someone appointed by the solicitor.

The escrow sum will be paid out of the account in the event of certain triggers. The terms of the escrow are recorded in an escrow agreement – most of the time, these terms will require the escrow sum to be topped up if paid out.

Direct Payment Arrangements

Direct payment arrangements in a construction project involve money moving directly from one party to another and bypassing the party in the middle. For example, the employer paying the sub-contractor directly and bypassing the main contractor.

Direct payments are used when the middleman (in this scenario, the main contractor) has limited financial stability. They protect the employer in the event that the contractor becomes insolvent by ensuring that funds paid are actually used in respect of the project rather than diverted to other projects. However, it is very important if any direct payment arrangements are to be to put in place that there is clear unambiguous wording in writing, otherwise disputes may arise and the employer may end up paying twice for the same work.

Conclusion

There are plenty of alternatives to bonds which are worth exploring now the market has become more difficult. The most important thing though is for the parties to consider what security they actually need and whether it is worth the price that is demanded – different forms of security come with different costs and difference risks.

The time to consider these things is prior to entering into a contract, because afterwards if there is no security required there will be no ability to demand it; and conversely, if a form of security has been offered that cannot be delivered (such as a bond) then the promising party may have a problem.

This article originally featured in September 2023’s edition of our Aggregate newsletter: to read the complete edition, click here.