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Home > Financial Instruments > Purpose of Gurantees / Bonds

Purpose of Guarantees / Bonds

There are different types of Guarantees/Bonds in use in the industry for different applications, a few of which are discussed below:

Tender Bond / Bid Bond – A Tender bond is a financial security submitted by a Tenderer in a prescribed format, for due fulfillment of Tenderers obligations under an ITT i.e. to accept a Contract, in case of being successful and, take actions to perform under its terms. In case of default it could be encashed/appropriated by Client.

The other school of thought for requesting a Tender Bond is, the Client stands to get better quality and more serious offers and cuts out the non serious Tenderers.

As much as practically possible, an auditable record of the reasons for requiring a tender bond and the logic behind its value should be committed to paper as part of the pre-tender activities

Tender Bond Value: is a fixed amount and for a certain duration upto the period which is the expected date of Contract award.

The value of a Tender Bond is thought to notionally represent compensation of the effort, in monetary terms, required to be put in by a Client in concluding a Contract with the next lowest or next acceptable Tenderer in case of a default by the lowest successful Tenderer.

There is no specific formula for calculating the value of Tender Bonds however generally as an extensively used suggestion is that for low value Contracts the bond value is around US$ 5,000 and for high value or large Tenders they could go upto US$ 100,000 and US$ 250,000.

Tender Bond Validity: The Tender bond is kept valid till Contract signatures and receipt from the Contractor of a Performance Bond. Since the award date is subject to change, the Bond should be suitably worded to contain a provision for extension at the request of the Client, unconditionally.

Advance Bond: In Contracts where there is an upfront financial commitment required by a Contractor towards its subcontractors or sub-suppliers or towards mobilisation of other resources, site set-up, etc, Contractors request for advance payment to meet such commitments. Clients seek a bank guarantee as a security / collateral for the amount of advance payment made to the Contractor.

Advance Bond Value: normally the advance bond amount is equal to the advance payment agreed to be made to a Contractor.

Advance Bond Validity: the guarantee is kept valid till such time as the advance payment is fully adjusted from the running invoices of the Contractor for work done. The adjustment is normally done by deducting an equal percentage (as that of the advance payment to the Contract price) from the gross value of running invoices for Work/Services done by the Contractor.

As in the case of a Tender Bond, in this case too it is not possible to foresee with certainty the expiry date of the Bond. Hence the Bond should be valid for an estimated time suitably worded to contain a provision for extension at the request of the Client, unconditionally. Though a Contractor or bank may have reservations on it being open ended, suitable alternatives should be negotiated to ensure bond validity till obligations are complete.

To free up precious bank guarantee limits (collaterals) with their banks, and to reduce costs, Contractors negotiate a reduction in the value (in steps) of the bank guarantee pari passu, to the extent that the advance paid by Client gets adjusted (work done) in the invoices.

Performance Bond:

Performance Bond or Guarantee is a guarantee, providing certain financial recompense to Client in the event of default by the Contractor in its performance. Unlike in the other Guarantees, a performance Guarantee may not necessarily be made specific to a Contract provision and is generally for the overall performance of the Contractor in accordance with the Contract provisions.

A Performance Bond is required if the Work to be performed or Service provided is of an "instantaneous" nature where failure to perform can be easily identified and the recompense gained can be used to engage an alternative Contractor. There are currently two forms of recognised Performance Bond, the default bond and on-demand bond while on demand bond is the most commonly accepted and used by Clients.

Many international forms of contract provide for Performance Bonds, generally at the option of the Client. These forms of contract also require that the Client can only call in the bond after the Contractor has been shown to be in default. Unless the Contractor is prepared to admit its default (which is rare and unlikely), this will inevitably involve litigation or arbitration. These default bonds can be unreliable security and are generally not sought by Clients.

General Client policy should be that where required, Performance Bonds should be of the on-demand format whereby it is only necessary for Client to give a simple written notice to the surety (bank) without the need for consent by the Contractor and/or requirement to produce evidence of default or as to the correctness of the sum demanded.

If a Performance Bond is considered necessary for a particular Contractor, serious consideration should be given as to whether or not Client should be placing a Contract with that Contractor particularly where the Work is of a critical nature.

The amount of the bond itself is usually 10% of the estimated final contract value (which may differ from the original contract price). In case of there being large variations in the Contract price midway thru the Contract, the amount of the performance Bond should be adjusted to reflect the correct Contract Price. This amount is considered reasonable insurance in most circumstances to cover the extra costs Client could incur should it be necessary to employ another Contractor to complete the Work through the default of the appointed Contractor to complete its obligations under the Contract. For larger projects a reduction in this figure may be appropriate.

A performance bond should cover the full range of the contractor's obligations under the Contract including warranty/defects liability period. As such, Performance Bonds should remain valid until expiry of the defects liability period or any extension thereto in the event that defects occur requiring an extension of that period for all or part of the works. They can be particularly useful for securing performance when the Contractor does not maintain a permanent presence in the place where the Client operates from.

Like in the other Bond wordings the Performance Bond should also have a clause for validity extension at Clients sole discretion.

Retention Money Bond Guarantee: not very popular in the oil & gas industry Contracts though often seen in use in FIDIC Contracts. The purpose of Retention Monies, generally applicable to construction Contracts, is to provide for partial payment to Contractor during the construction duration of the Contract and defer payment in full of the balance until such time as the Contract completion date has not been achieved. It is perceived to act as a financial security for the Client in case of any default by Contractor. It also acts as an incentive for the Contractor against possible default and to complete the Works within the agreed completion date. Retention monies are immediately available to Client in case of any defects that need to be rectified that the Contractor is unable to rectify expeditiously.

Since Retention Money effects Contractors cash-flow directly, they are in practice more effective as compared to a bank guarantee. In case of a default, encashing a guarantee could take time and also could get possibly stuck in legal wrangles.

The amount of retention is normally a certain percentage of the invoice values e.g. 2.5 % or 5 % or 7.5 %. A fixed percentage is deducted from each of the running payments to Contractor until the cumulative value of such retentions reaches a certain percentage of the total Contract value.

Since such a percentage retention affects the cash flow of the Contractor, during the Tender negotiation phase Contractors often negotiate furnishing a Bank Guarantee instead, thereby improving their cash flow. Also, holding monies could have a more profound effect on finances of both the Contractor and Client as opposed to a bank guarantee as, financial costs of retentions could far outweigh the bank guarantee fees charged by a bank.

Normally at achieving Provisional Acceptance, the value of the retention money Guarantee is reduced by 50 % of its value and released upon issue of a Final Acceptance Certificate at expiry of the Defects Liability Period.

The wording of the Retention Money Guarantee is similar if not the same as that of the Performance Guarantee.

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