Security is a key feature of construction contracts. It is important for both the principal and contractor to understand the nature and purpose of security, the associated risks and benefits and how to adapt security to each contract.

 

What is ‘security’?

‘Security’ is a financial assurance given by one party to another to ensure the due and proper performance of its obligations under a contract. In most construction contracts, security will be given by the contractor to the principal. In some cases, the principal might also be required to provide security to the contractor, but this is less common and typically only arises where the ability of the principal to satisfy its obligations to make payment under the contract is in question. This article will assume security is given by the contractor to the principal.

 

The security requirements will be defined by the terms of the relevant contract, but the common expectation is that security will be ‘as good as cash[1],’ that is, immediately and unconditionally accessible by the principal.

 

Types of security

Security comes in a range of forms, each with different financial, commercial and legal considerations to be taken into account. The most common forms are retention money, bank guarantees or insurance bonds:

Retention Money
A percentage of the contractor’s progress claims is withheld until the principal holds the agreed amount of security.
Benefits:

  • Simple
  • No upfront costs
Risks:

  • Hinders the contractor’s cash flow
  • For principals, the full value of security is not held immediately upon commencement of the works
  • Legislation may also impose administrative burdens on the holder of retention money[2].
Bank Guarantees
A bank or lending institution undertakes to pay a specified sum of money upon the occurrence of a specified event (the required terms/form of bank guarantee should be specified in the contract).
Benefits:

  • Doesn’t impact on the contractor’s cash flow over the course of the project (but upfront cost).
  • If properly drafted, immediately and unconditionally accessible by the Principal (an unconditional bank guarantee can be claimed without demonstrating a contractual right to the issuer[3].
Risks:

  • Banks usually require security from the contractor (typically cash) which can pose substantial upfront costs.
  • Principals will need to ensure the bank guarantee is properly drafted (i.e unconditional and on demand).
Insurance Bonds
Similar to a bank guarantee, but provided by a third party insurer (usually an insurance company) rather than a lending institution.
Benefits:

  • Doesn’t impact on the contractor’s cash flow
  • In most cases, the issuer doesn’t require security so there is no upfront cost either.
Risks:

  • Can be expensive for the contractor if security is called upon
  • Principals will need to ensure proper drafting (i.e. unconditional and on-demand)
  • Principals should also satisfy themselves with the financial standing of the issuer and the process for calling on the bond (which can be practically more difficult than a bank guarantee)

 

Pitfalls of security

A call upon security can be damaging to the party who provided that security. In addition to the direct financial consequences, it can negatively affect a party’s credit rating, reputation, ongoing commercial relationships and ability to obtain security in the future.

The principal’s right to call upon security should be defined by the terms of the relevant contract (including whether prior notice to the contractor is required). However, it is generally difficult for a contractor to resist a call upon ‘unconditional’ security. In Clough Engineering Ltd v Oil & Natural Gas Corp Ltd (‘Clough Engineering’) [4], the High Court considered the circumstances in which an injunction will be granted preventing the principal from calling on security:

1. recourse is fraudulent;

2. recourse is unconscionable; or

3. the principal has made a contractual promise not to call upon the security (i.e. the underlying contract includes a qualification on the principal’s right to call on security).

In light of this narrow protection, contractors should ensure that the principal’s contractual right to have recourse to security is appropriately qualified and that a reasonable notice period is provided so that the contractor can consider effective action (whether commercial or legal) to avoid or mitigate the impacts of a call on security.

Despite their relatively broad ability to call upon security, Principals should generally be careful not to do so without a contractual entitlement. The contractor may be entitled to damages for a wrongful call, so principals should ensure that the security regime is drafted to allow them to have recourse to security in the desired circumstances and manner.

Take away

Security requirements should be considered in the individual circumstances of each project, taking into account value, risk, complexity and timelines. The contractual security regime should be carefully drafted to align with those circumstances and the expectations of both parties. Both contractors and principals need to understand the effect, commercial and legal consequences and potential risks of their contractual security regimes.

If you have any questions regarding security in construction contracts, please do not hesitate to contact us at Morrissey Law and Advisory.

 

[1] Wood Hall Ltd v Pipeline Authority (1979) 141 CLR 443 [457] (Stephen J).
[2] For example, in NSW, retention money held by a head contractor in relation to projects valued at over $20 million must be held in a trust account with an authorised deposit-taking institution.
[3] CPB Contractors Pty Ltd v JKC Australia LNG Pty Ltd [2017] WASC 112
[4] Clough Engineering Ltd v Oil & Natural Gas Corp Ltd (1999) 15 BCL 158

Disclaimer: This publication by Morrissey Law & Advisory is for general information and commentary only and should not be considered or relied upon as legal advice. Formal legal advice should be sought in relation to any matters or transactions that may arise in relation with communication.