Bonding with the supplier market

With construction continuing to be a growth industry, how can Employers effectively engage with suppliers and mitigate against poor performance or non-delivery?

A number of iconic projects are to be completed in Dubai this year with many more large-scale infrastructure projects in the pipeline before Expo2020. DMCC has its own iconic project to deliver, the Burj2020 District, a world-class, mixed-use and integrated urban development within the DMCC Free Zone. Evidence suggests Dubai will continue to depend on the construction sector as a major contributor to economic growth bringing into sharp focus the need for Employers to attract and engage Dubai’s highly competitive supplier market. Whilst a large pool of contractors exists and competition is fierce, the market is demonstrating a cautious approach to new contracts which is manifesting itself in the commercials and may  restrict competition.

As in-house counsel, we have a duty to protect the Employer from unnecessary financial and performance risk when contracting. During a procurement, tenderers are rigorously evaluated through financial due diligence and assessment of technical, commercial and legal tender responses. The procuring process is intended to alleviate Employer concerns with contractors’ ability and project costs however Employers often request that contractors provide layers of additional protection in the form of tender bonds, performance bonds and parent company guarantees (PCG). Additionally, any contractor request for advance payment will be met with an Employer demand for an advance payment bond and a request for early release of retained monies similarly would require a retention bond.

The market is bullishly responding to Employer protection measures. Of late, responses to Employer requests for PCGs are met with reluctance and in several cases contractors have offered performance bonds instead. One does not equate to the other of course – a PCG, given by a parent covering all contractual obligations including stepping-in, providing resource, performance and financial indemnity does not equate to a contractor providing a performance bond that covers the cost of defects, termination and non-performance to a capped value (typically 10 per cent of contract value). Larger contractors can afford to price into their commercials the upfront bank costs associated with providing bonds and, whilst this can tie up capital, it is preferable to a parent being ‘on the hook’ under a PCG for the life of the contract. For the smaller contractors, requests for bonds and retention of contract funds can create cash-flow fluidity problems that can deter them from tendering. These contractors often do not have parent companies making the performance security more important but at the same time highlighting a legitimate risk to the Employer that capital tied up in bonds may hinder the contractor’s delivery. An unenviable ‘catch-22’ scenario arises for the Employer – if smaller contractors cannot afford to bond their performance or have monies retained, then this leaves the large contractors to bid, many of whom will either not bid for smaller works packages or will bid and reflect their appetite for the work with an inflated commercial submission. The alternative is for the Employer to increase its risk appetite and relax its requirements which doesn’t always sit comfortably with the Employer. The Employer’s dilemma becomes how to attract contractors proportionate to the size and scale of the works and at the same time cover the financial and performance risks associated with those works packages.

Contracts and procurement professionals are being challenged more than ever by their internal clients to apply a greater degree of pragmatism to Employers performance security requirements. Performance and delivery risks can never be completely eradicated however we must foresee and mitigate those risks through contractual arrangements. When put on the spot, few lawyers will confidently suggest significant reductions in the value of performance bonds, doing away with the need for PCGs or retaining less money. It is clear however that a greater depth of assessment must be undertaken on a case-by-case basis within the ‘time, cost, quality’ framework as to type and length of works, size of contractor and appropriate performance security. Employers require to strike a balance between protecting themselves against risks and taking a practical approach so as not to detract suppliers from tendering or inflating prices considerably beyond budgets.

Columnist:

Shonagh MacVicar, head of contracts, DMCC