There has been a noticeable increase in small and medium enterprises (SMEs) being asked to provide guarantees when participating in government construction projects.

These types of instruments relate to the contractor's performance of all terms and conditions of a construction contract. They protect the beneficiary, being government, against financial loss when performance on the project becomes problematic.

"But many small business owners struggle to obtain these guarantee bonds or sureties from the financial services market," says Honest Chikeya, executive of underwriting and reinsurance at PCBS.

The issuing financial institutions will only offer these guarantee facilities after engaging in a thorough process which pre-qualifies the contractor for such a facility.

In-depth look at operations

This process takes an in-depth look at the contractor's business operations, its financial strength to support the guarantee, and its ability to meet financial and contractual obligations. It also considers if there is a clean credit history; an established bank relationship and line of credit; adequate capital equipment for the specifics of the project; and suitable industry ratings.

Chikeya says this is where SMEs often run into difficulty. "These contractors do not always meet all pre-qualification criteria and tend to have lower Construction Industry Development Board gradings. Regrettably, many will not qualify at all for guarantee products. And if they do, these products would generally come with strict and expensive terms and conditions, as well as high premiums and high cash collateral requirements."

If the contractor does not secure the specified guarantees, the tender they have won could fall through. Or else the owner of the contract, being government, could insist on a retention, which is a predetermined deduction throughout the duration of the contract. "While the contractor will eventually recover all these retentions at the end of the contract when he has performed successfully, these initial and ongoing deductions will significantly undermine the cash position and margins of the small business," says Chikeya. "And even worse, the retention could compel them to borrow expensive funds in order to finance the project."

Demand guarantee

Besides facing numerous problems in securing the requisite guarantee facilities, Chikeya points out that SMEs also face challenges when a demand guarantee is required by the owner of the project. "Sureties are less risky for SMEs as they require the project owner to provide proof that the contractor has not delivered on its obligations and that there has been consequential loss.

"In contrast, a demand guarantee can be called up regardless of any disputes between the contractor and the employer, there is no quantification of financial loss required and it does not take into account any contractual defence to the cancellation of the contract that the contractor may have. But the insurer still has to pay the beneficiary and will recover this from the contractor, perhaps even forcing this small business into liquidation."

When a guarantee is indeed called up and the contractor has reasonable grounds to challenge and wishes to challenge the cancellation of the contract, they have to interdict to try and prevent the insurer from paying out, or in arguing that it should not have to reimburse the insurer for any payouts made. "It is concerning that there are a number of contractors being liquidated due to issues stemming from contractual disagreements resulting in guarantee claims, for demand guarantees, where these disagreements could have been resolved " says Chikeya.

For all these reasons, specialist insurers are reluctant to issue demand guarantee products to SME contractors.

Bank collateral

For those who cannot access a demand bond from an insurer, there are the more traditional bank guarantee facilities. "But these are usually issued on a 1:1 basis, meaning that the required bank collateral has to be equivalent to the guarantee value," says Chikeya. "This is often a difficult requirement for a small business. That collateral outflow reduces working capital and hence operational performance, perhaps to the extent that the contractor fails to execute a project on time or complete it at all. The collateral payment also reduces funds available to pay back debt or tender for more contracts. "

Chikeya's concern is that SMEs struggle to get demand guarantees and, if they do get them, it is costly, and this affects their performance. The restricted access to the demand guarantees also delays the start of most projects resulting in them being delayed in the end and the contractor will pay penalties. The SMEs also suffer in cases of unfair cancellation of contracts and unfair call-ups of the demand guarantees. He urges government to examine how SMEs can get easier access to construction insurance and guarantee products that are within their means/reach. 

"These businesses are at the heart of our economy, playing a role in transformation and creating much needed employment. Governmental institutions need to consider how SME contractors can be supported in terms of their contractual obligations, which includes the provision of construction insurance and guarantees, as this ultimately determines their success and growth." This can be done by allowing SMEs to provide sureties which can easily be obtained and at an affordable price and reasonable collaterals.

Source: www.bizcommunity.com/

Posted on : 30 Nov,-0001