Bank guarantee

The contractor arranges a guarantee from its bank in favour of the principal for the security amount the contract requires. The bank usually needs the contractor to hold a facility or cash backing for the same amount.

Most construction contracts require an unconditional guarantee. That means the principal can make a demand and the bank must pay, without the principal first proving the contractor is in breach. The principal's right to call on the guarantee is then governed by the contract, which usually requires a claim for money owed and sometimes a notice period first.

Contractors also take bank guarantees from subcontractors, so the same arrangement often runs down the contract chain.

Both standard contracts deal with security in clause 5, covering how security is provided, when it can be used, and when it is reduced and released.

• AS 4000-1997. Clause 5, Security.

• AS 2124-1992. Clause 5, Security, retention moneys and performance undertakings.

• Your contract. Check the amount, the form of guarantee, any notice the principal must give before calling on it, and the release dates.

Both are forms of security. Retention is cash the principal holds back from each progress payment, which reduces the contractor's cash flow throughout the job. A bank guarantee is lodged up front and does not reduce progress payments, but ties up the contractor's bank facility and attracts fees.

Security is commonly reduced at practical completion and released after the defects liability period ends. Some states have rules on how retention must be held, so check local security of payment legislation. Insurance bonds from approved insurers are another option some contracts accept.

Most contracts allow the principal to have recourse to security when money is owing to it under the contract and has not been paid. Common examples are unpaid liquidated damages, the cost of fixing defects the contractor failed to rectify, or amounts owed after termination.

Many contracts require the principal to give the contractor written notice of its intention to call on security a set number of days beforehand. That gives the contractor a chance to pay or dispute the amount. A call outside the contract's terms can be challenged, and in urgent cases contractors sometimes seek a court order to stop it.

Because an unconditional guarantee is paid on demand, the dispute about whether the money was really owed usually happens after the bank has paid.

• Wrong wording. Principals often require a set form. A guarantee in the wrong form can be rejected and delay payment.

• Missing release dates. Track when each guarantee should be reduced or returned, and ask for it in writing.

• Letting expiry dates lapse. If a guarantee has an expiry date before the security is due for release, the principal may be entitled to call on it.

• Not matching subcontract security. Make sure security taken from subcontractors covers your exposure to the principal.