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10 WAYS HOW SURETY BONDS SCORE OVER BANK GUARANTEES
Posted by Vikash Khandewal on Nov 22, 2020 7:00:00 PM
The World over, Surety Bonds have emerged as a safer, more convenient and reliable mechanism of providing non-funded support to contractors. This support extends end-to-end – right from the bidding phase till completion, even the defects liability period!
Traditionally, in India, Bank Guarantees have been the mainstay of banks and the go-to for construction/infrastructure companies. This is all set to change, considering the clear cut benefits of Surety Bonds over Bank Guarantees. Before we look at those advantages, let’s take a quick look at India’s economic growth scenario.
The Infrastructure Sector is a key driver for the Indian economy. It includes power, bridges, dams, roads, and urban infrastructure development. With huge Investments in the offing, there are risks involved like time and cost overruns and non-fulfilment of obligations. Due to this potential risk, the financial sector offers a cushion in the form of Bank Guarantees which liens the collaterals and blocks cash margin money. This forces the Contractors to struggle to mitigate the liquidity crisis they end up facing.
It’s no surprise that Banks are now increasingly unwilling to lend to the infrastructure sector as it requires a longer gestation period and maturity time for performance along with the urgent need to keep a check on its NPAs.
This has given rise to the need to an alternative to Bank Guarantees along with a robust system to support the Sector for surety of payments and Risk mitigations in the event of defaults. Surety Bonds have emerged as an alternative to Bank Guarantees in this rapidly growing and competitive environment. Though the concept is new to India, it has been mandated by law on public works projects as an alternative instrument for financial security in countries like the US and numerous other developed countries.
THE GOOD NEWS: SURETY BONDS ARE HERE
Surety Bonds are an agreement among three parties, the Surety COMPANY (Guarantee Provider), the PRINCIPAL (Contractor) and the OBLIGEE (project owner). The Surety provider offers this assurance based on its assessment of the Principal along with its expertise in both the financial and industry knowledge.
With the advent of this new tool in the Indian Financial Ecosystem Surety Bonds have emerged as an efficient alternative to Bank Guarantees for similar assurance requirements. Bank Guarantees have a nature of On Demand honouring of the payments, however, in the case of Surety Bonds, the structure is such that each party has an obligation to each other:
The PRINCIPAL has the duty to the OBLIGEE to perform its contract. The OBLIGEE likewise owes a duty to the principal to uphold its end of the contract, including payment in accordance with the contract terms.
The SURETY has a duty to the OBLIGEE to take action under the terms of the bond if the PRINCIPAL defaults under the contract. But the OBLIGEE has a duty to fulfil its bargain under the contract, again, including payment of any sums due under the contract, but this time to the Surety that performs and withstands to the terms.
The SURETY has the duty to determine whether the PRINCIPAL is in default and abide by the terms of the bond and any agreement of indemnity. The PRINCIPAL must co-operate with any investigation of an allegation of default and reimburse the Surety for any losses incurred due to the default of the principal on its promise.
Surety Bonds have an inherent advantage over Bank Guarantee as illustrated below:
► MORE CREDIBILITY: A Surety is an obligation accepted by the Guarantor to make a payment to a beneficiary if certain terms of the contract are void whereas a Bank Guarantee is an assurance given by the Bank to the beneficiary to make a specified payment in case of default in the terms of the contract. This strengthens the integrity of the parties involved to the terms of the contract.
► BETTER LIQUIDITY: Surety Bonds can be viewed as an alternative to the Bank Guarantees which do not require margin/cash collateral. They frees up the working capital originally stuck as margin money/lien saving the contractors cashflow, strengthening their ability to complete projects on time and use the available funds for other avenues to strengthen the business.
► THE ASSURANCE: The Surety Company has a comprehensive process of investigating the reasons and aspects of Contractors default unlike Bank Guarantee which has a nature of on-demand honouring the claim, thus saving the interests and rights of all the parties involved.
► RISK MITIGATION: he risk of the performance of the Contract is assumed by the Guarantor and it is its obligation to assure the mitigations in terms of the Contract whereas in the case of the Bank Guarantees the primary risk is assumed by the Contractor in the event of the non-performance of terms of Contract. Hence Surety Bonds would be a preferred mode of financial guarantees which a contractor would generally submit in the normal course of its business.
► WIDER COVERAGE: Surety Bonds have a wider coverage as compared to the Bank Guarantees. Along with Contract Surety and Commercial Surety the Surety Bonds also cover the ambit of Rentals in the form of Rental Bonds which covers the risks related to Rents; lock in period, wear and tear and damage of the property. This would entail many new clients looking for such guarantors in the real estate space.
► BETTER CONTRACTORS: Once a Contractor is known to a Surety Provider it becomes easy to evaluate projects and issue appropriate bonds. The Surety Company turns out to be an important partner in the bidding and project development phase unlike a Bank which is limited to its payment obligation.
► LOWER COST: As opposed to a Bank Guarantee which can lock up 8-10% of the project cost for the Contractor, a Surety Bond costs just 1-3% of the Bank Guarantee amount.
► SOLID BACKING: Bank Guarantees are backed by individual financial institutions, whereas Surety Bonds have the backing of a network of global giants in the domain. The Surety Bonds of Eqaro for instance are backed by SOPAC, Northern Light and Ion Insurance.
► CLAIM PROCESSING: Since the Surety Company specialises in the domain, it will have a number of alternatives in the event of a claim. They include financing the contractor or providing necessary support to finish the project, arrange for a new contractor to complete the project or assume the role of a contractor and sub-contract out the remaining work. On the other hand, since banks have expertise in other domains, they will be inclined to pay out and demand reimbursement from the contractor.
As a Surety Bond is issued after proper due diligence of the Client with respect to contractor’s history, capacity, financial strength, character, credit history and a host of other factors in lieu of Guarantee Fees, the credibility of the Contractor is established better in the market.
Also with the available liquidity in hands the Contractor finds more flexibility to use the funds which otherwise would have been stuck in the form of margin money if it would have opted for Bank Guarantees. This additional boost of liquidity strengthens the economy at large enabling a robust holistic growth of the ecosystem which is currently facing credibility issues due to piling up NPAs. Analysis of the nature of the problem reveals that many of the project contractors had placed unrealistic low bids to win projects and eventually many of those ran into financial problems and ultimately those projects came to a standstill. This can be bypassed if we have a vibrant Bonds market in India.
Topics: Surety Guarantees, Eqaro Guarantees, Bank Guarantees
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