How To Use Bank Guarantees For Long-term Project Contracts?
A bank guarantee is a type of legal document where the issuing bank or financial institution guarantees that if the certain borrower fails to pay the loan on time or defaults in performing the terms & conditions of the contract, then the losses will be covered by the bank or financial institution.
It not only enables the borrower to purchase equipment, machinery, or raw materials for completing their trade transactions but also assures sellers that they would be paid on time. But do you know that a bank guarantee can also be used as a project guarantee to manage the risks and safety of a trade deal that involves long-term projects like construction contracts? Let’s read how.
What Are Project Guarantees?A project guarantee is a type of bank guarantee where the issuing bank promises that in the event if the company carrying out a particular project defaults or fails to deliver the predetermined services, the bank will cover the costs or losses. This type of guarantee is generally achieved using a work clause that enables vendors to initiate the project. The main purpose of issuing a project guarantee is to secure the beneficiary.
How Do They Work?Long-term projects, such as construction contracts involve many parties working together for a significant amount of time until the completion of the project. The contractor performs specified construction requirements like constructing a building as specified by the employer under the project, within the agreed time. In return, the employer agrees to pay the contractor a certain price.
Let’s understand this through an example. Imagine Company A hires a contractor to construct a building. The contractor now further needs to hire vendors and subcontractors to complete the project. Since these construction contracts usually take a longer period to be completed and the contractors don’t get the payment until the work is completed, it generates high risks of default for both the contractor & employer. The employer is at the risk of the contractor not performing the work at all or under the regulations, while the contractor is exposed to the risk of the employer failing to pay the agreed price after the work is done.
In this scenario, a project guarantee ensures parties to the contract that they will be paid on time for the work they have completed. This is why a project guarantee is important for mitigating the associated risks in long-term projects. While signing the contract, they propose various types of project guarantees as collateral to protect their interests from associated risks.
Recommended Read: What Is The Difference Between Bank Guarantee And Letter Of Credit?
Types Of Project Guarantee Issued For Securing A Construction Contract
Depending on the associated risks that an employer wants to secure in a long-term project, there are three types of project guarantees. Here they are as follows:
1. Advance Payment Guarantee
2. Performance Guarantee And
3. Defect Liability Guarantee
Advance Payment GuaranteeAdvance payment guarantee is a type of project guarantee where the issuing bank pays a certain amount of money to guarantee the beneficiary ie. the employer, in the event if the contractor fails to deliver the services as per the contract for which he received the advance payment.
In simple words, when an employer pays an advance amount to a contractor under the construction contract before the commencement of the work, this guarantee enables them to secure such an advance amount. The employer can get the advance payment back in full in case the contractor doesn’t fulfill the contractual obligations at all or the employer is not satisfied with the provided services.
Defect Liability GuaranteeIt is a type of project guarantee where the bank agrees to pay the possible claims to the beneficiary ie. the employer in case the delivered or performed work is not as per the standards or has defects. The guarantee period can last from 12 months up to 10 years depending on the parties’ concerns and the value of the performed work. Also, if the agreement mentions a compulsory issuance of a defect liability guarantee, and the contractor doesn’t provide the guarantee, the employer can collect a performance guarantee.
Long-term projects involve parties from multiple nations and therefore, it is recommended to approach a guarantee or other trade finance services from a reputed institute like Emerio Banque. The team of experienced & professional financial advisors is well-versed in tackling complex projects globally and can assist clients according to their needs.
Here we have listed some of the most commonly asked questions about bank guarantees, take a look: Bank Guarantee FAQs