Types of security

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

Cash retention

Cash security is typically held by the principal by deducting a retention from progress payments.

It is helpful to have the 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 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 a promise to pay an amount, typically unconditionally and on demand.

EXAMPLE

'At the request of [the contractor] and in consideration of [the principal] accepting this undertaking in respect of [contract description], [the bank] unconditionally undertakes to pay on demand any sum to a maximum aggregate of [amount].'

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

Insurance companies provide insurance bonds as undertakings. Usually the contractor does not provide the insurer with security. The insurer will 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 a subsidiary of another company ('parent company'), the principal may require a performance 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.

EXAMPLE

AS4000 clause 5.6:

'Where a party is a related or subsidiary corporation … that party shall … provide [a] deed of guarantee, undertaking and substitution duly executed and enforceable.'

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.