In the building and construction industry, various forms of security are used to provide assurance and protection for contractors, subcontractors, and other stakeholders. Bank guarantees and cash retention are two common forms of security used in Australia’s building and construction industry.
Both serve the purpose of ensuring work is completed to the agreed upon standard and demonstrate a willingness to perform contractual obligations. However, each method has its pros and cons and it is important to understand these before deciding which form of security to use.
Bank Guarantees
A bank guarantee is a type of financial instrument issued by a bank on behalf of a customer (the ‘issuer,’ typically a subcontractor) to provide a form of security or assurance to a third party (such as the head contractor, known as the ‘beneficiary’ or ‘favouree’). It acts as a promise from the bank that it will pay a specified amount of money to the third party if the subcontractor fails to fulfil their contractual obligations.
Here are some pros and cons of using bank guarantees in the building and construction industry:
Pros:
- Reduced financial risk: Bank guarantees remove the risk of losing retention monies if the head contractor goes into liquidation or administration.
- Improved cashflow: Receiving progress payments in full can increase cashflow and capacity to meet obligations to other subcontractors and/or suppliers.
- Faster return: Bank guarantees are generally returned to the subcontractor faster than retentions because their return does not impact on the contractor’s cash position.
Cons:
- Cost: The subcontractor or issuer generally deposits an amount of money equal to the bank guarantee with the bank for the term of the bank guarantee which can have a significant impact, particularly for small businesses.
Note: Financing the security can help mitigate the impact, allowing the subcontractor to preserve their working capital and pay back the security over time. Find out more about Assuro’s Bank Guarantee Finance. - Administration: The traditional process of obtaining a bank guarantee from a business bank requires additional administration and paperwork, which can be time-consuming and add to the administrative burden of a project.
Note: The Assuro platform is 100% digital, eliminating paper-based application forms. The online application streamlines the process for all parties and significantly reduces turnaround times. Find out more about Assuro’s online bank guarantee application. - Management and support: Banks generally don’t offer ongoing management or support to clients for their bank guarantees, resulting in manual tracking of expiry dates, renewals, and payment of fees.
Note: Assuro provides a suite of management tools to manage financial instruments. Replacing Excel, users can track and manage their guarantees in one place with features like custom alerts and custodian tracking for better visibility and tighter control over financial securities. Find out more about Assuro Cloud.
Cash Retention
Cash retention is the simplest form of security and common practice in the building and construction industry. It involves the withholding of a certain percentage of a subcontractor's progress payments (usually 5% of the total contract amount) until the project is completed to the satisfaction of the head contractor.
The withheld funds are held by the contractor and released to the subcontractor once the project is completed in accordance with the agreed-upon terms and conditions or until any defects or issues have been rectified.
While cash retention can be a convenient form of security, subcontractors should be aware of the associated risks given the cyclical nature of the building and construction industry. Here are some pros and cons of using cash retention:
Pros:
- Provides incentive for completion: Cash retention can motivate subcontractors to complete the project on time and to a high standard, as they know they will not receive the full payment until the project is finished.
- Cost-effective: Cash retention is typically less expensive than bank guarantees, as it does not require a fee to be paid to a third party.
- Flexibility: Cash retention allows the head contractor to retain a certain percentage of the contract price, giving them more control over the project budget.
Cons:
- Financial risk: Cash retention can pose a significant financial risk for subcontractors, particularly smaller businesses, as they may have to wait for an extended period to receive payment for work done, or risk losing retention monies if the contractor goes bankrupt or is unable to pay.
- Administrative burden: Cash retention requires additional administrative work as the party who engaged the subcontractor must keep track of the amount being withheld and release it in accordance with the contract terms and legislative payment period.
- Unfair practices: In some cases, the head contractor may use cash retention as a way to delay payment or unfairly reduce the amount paid, causing financial hardship for the subcontractor.
Legislation
Long-standing concerns about payment delays and disputes in the industry has called for reform to improve payment practices and protections for subcontractors in the building and construction industry.
WA’s Security of Payments Act, which was introduced in 2020, aims to provide greater certainty and security for subcontractors by establishing clear payment terms and dispute resolution mechanisms.
Each state and territory in Australia generally has its own version of the Security of Payments Act, which provides protections and mechanisms for ensuring that subcontractors receive prompt and fair payment for their work. These Acts also establish requirements for progress payments, payment claims, and dispute resolution mechanisms.
The basic principles of the Security of Payments Acts in Australia are similar across all states and territories and although the Acts have been generally well-received, like any legislation, there are potential drawbacks:
Increased Administrative Burden
Compliance with the Security of Payments Act can be time-consuming, involving a significant amount of administrative work. The Act requires detailed documentation to be provided at various stages of a construction project, which can be a drawn-out and burdensome process for all parties involved.
Complexity and Costs
The level of complexity can be difficult to navigate, particularly for smaller contractors and subcontractors who may not have the resources to engage legal or professional assistance. This may also increase the overall cost of construction projects, particularly for those smaller contractors who may not have the resources to absorb additional administrative and legal costs.
Potential for abuse
While the Security of Payments Acts provide protections for subcontractors, they may also be open to abuse by unscrupulous contractors who use the dispute resolution mechanisms to delay or avoid payment.
It's important to note that the specific details of each Security of Payments Act may vary and that there may be additional requirements or variations depending on the type of construction contract, the value of the project, and other factors. It's recommended that parties in the building and construction industry seek professional advice or guidance on the specific requirements that apply to their particular circumstances.
Choosing a security
When deciding which form of security to use, subcontractors should consider the specific risks and challenges associated with the project they are working on such as the size and complexity of the project, the level of risk involved, and the financial stability and reliability of the other parties involved. Subcontractors may also wish to consult with industry experts or legal professionals to determine the most appropriate form of security for their circumstances.
Both bank guarantees and cash retention have their pros and cons, and it is essential to understand the financial risks, costs, and administrative burden associated with each method before deciding which form of security to use.
Important notice: The information provided is general information only and does not take into account the objectives, financial situation or needs of any particular person. Accordingly, persons should consider the appropriateness of the information having regard to their own objectives, financial situation and needs and should seek professional assistance as necessary. Information accurate at date of publication.
