Disputes between the Investor and the Contractor regarding the bank guarantee. Solutions for the future

Misuse of a bank guarantee and the limitation of the Contractor’s creditworthiness

Construction Contractors often face the situation of unauthorized execution of a bank or insurance guarantee by Investors. The problem is widely known in the practice of construction contracts. Especially when using unconditional and payable on first demand security, which is intended to make it easier for Investors to satisfy their claims. However, misuse of the guarantee has far-reaching financial consequences for the Contractor. In addition to the need to return the recourse claim to the Guarantor, the Contractor must consider indirect costs related to the financial servicing of implemented contracts.

Each request for payment of security issued at the request of the Contractor does not remain without impact on its overall assessment and creditworthiness, which are examined by financial institutions. Before granting security, the Bank analyzes the financial position and history of the Contractor (i.e. the entity ordering the issuance of the guarantee), which has a direct impact on the availability and cost of the offered financial instruments. When the Guarantor Bank notes that there is an increased risk of payment of security in relation to a specific Contractor, it will appropriately include the cost of risk in the price of the security issued.

The described dependency does not apply exclusively to the Contractor. Increased investment implementation costs are ultimately included in the cost estimates of the offers prepared by the Contractors and the value of the remuneration paid by the Investor. In the short term, an unjustified demand for a guarantee may be beneficial for the Investor. In the long term, however, it generates costs for both parties to the construction contract.

Problematic extension

A related problem is the phenomenon of the Investor forcing the Contractor to extend the period of the security provided.

At the final stage of the investment, a dispute often arises about the quality of the work performed. The Investor claims that the Contractor has not performed the permanent works and demands an extension of the security for the proper performance of the permanent works. The Contractor takes the position that the contract was performed correctly. The dispute leads to the Investor presenting an alternative: the Contractor extends the security, or the Investor submits a preventive demand for payment of the applicable guarantee.

This phenomenon is particularly disadvantageous, as it leads to the accumulation of liabilities on the Contractor’s side, i.e. it leads to the Contractor being bound by multi-year bank guarantees issued on their behalf. Due to the lack of release from liabilities issued as part of various investments, Contractors have an increasing problem in obtaining security to cover subsequent investments. After the credit limit is exhausted, primarily smaller local Contractors with limited capital have difficult access to new orders. Problems with financial liquidity understood in this way are increasingly common, which may lead to a violation of competitiveness on the construction investment market.

Postulated solutions

In general, the remedy for the outlined problems consists of the Investor examining each time the justification and necessity of using the granted security. It is not always necessary to implement the entire security – e.g. in the event of a compromise on the partial recognition by the Contractor of the demands raised by the Investor.

In practice, Investors should abandon the implementation of preventive demand for payment of the sum insured, which is particularly dangerous in the context of increasing security costs. This applies, for example, to situations where the Investor demands payment of security and only then presents the Contractor with justification by later creating claims for contractual penalties for improper performance of the contract.

Another proposed solution should be the broader use of the conditional guarantee model. It is worth considering a variant in which the condition for the payment of the guarantee will be the presentation of an opinion prepared by an independent expert, previously agreed by the parties to the contract, together with the request for payment.

At this point, we should fully support the emerging openness of the Public Procurement Authority to out-of-court methods of resolving disputes, e.g. in the form of proceedings before the PGRP, and postulate the Public Procurement Authority’s broader use of the assistance of independent experts.

Finally, it is worth emphasizing that an unauthorized demand for a guarantee payment affects the cost of the entire investment and the value of offers in subsequent orders. Hence, it should be in the well-understood interest of both parties executing a construction contract to limit the risks related to the abuse of a bank guarantee.