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Construction: at the cutting edge of guarantees
Guarantees are a vital mechanism for assuring trust and mitigating risk, and the greater the value at stake, and the more complex the project, the more important guarantees become. The construction sector is a perfect example. In major construction projects, contracts might be valued at hundreds of millions of euros and take years to complete. As a result, the construction sector uses bank guarantees extensively and in many different ways — perhaps more than any other sector. We spoke to Elisabeth Berg, legal counsel at Skanska, about her experiences and how Skanska gets the most from guarantees. She identified five best practices:
1. Balance central and local management
Skanska’s subsidiaries issue hundreds of guarantees each month, each of which remains active for a number of years. Six months into 2016, Skanska had more than 10 billion SEK in bank guarantees issued. With this volume of activity, strong centralised control is vital — but so is management at a local level. “We have centrally negotiated guarantee facilities with a core group of banks, and we centrally monitor the spread of banks that we’re using,” says Berg. “We’ve made sure to negotiate consistent terms across all our banks and insurers, and we have defined triggers within our project processes that get central teams involved at the right time. But otherwise all the administration of receiving and issuing guarantees is handled in the local business’s finance department.” The use of guarantees will naturally draw in multiple departments, including legal, the treasury, and the project teams negotiating with customers and subcontractors. Berg notes that discussions between these teams are important: “Guarantees are a key part of our discussions about risk exposure, and how we work with our group of banks generally,” says Berg.
2. Prepare and standardise to streamline the process
Guarantees tends to be discussed in the middle of a project’s negotiations, and stakeholders from treasury and legal aren’t always involved from the start. “You will probably be squeezed in time and have to make late changes,” says Berg. There are a few things you can do to make this process easier. The first is to have all the documentation in place ahead of time with your banks, and have defined a clear process with them for how they issue and amend guarantees. Another is to agree a standardised wording for the guarantees you issue, as much as possible. This benefits all parties in the process, in terms of avoiding risk and uncertainty, leaving the guarantee process to be mainly about deciding on cost and percentages. Take a look at Nordea’s guarantee templates — they offer a proven foundation for your customisation. Your industry trade bodies may also publish guarantee templates reflecting standard practice in your sector. However, the reality is that in complex projects, a smooth process depends on having the right people and a collaborative attitude. “Everyone wishes they had more time, but overall it works for us,” says Berg. “We have a close relationship with our banks, so we can come in to the process quite late and still get a good result.”
3. Work closely with the right core banks
The kind of relationship that Berg describes doesn’t just happen by accident. Berg advises looking for banks that have knowledge of your market in the first instance, and maintaining regular dealings so that they’re primed to respond quickly when urgent requests arise. “A bank’s flexibility, speed and reliability matter to us. So does its familiarity with our sector. It’s comforting to know that the person on the other side of the table understands what’s normal practice in your industry when amending a guarantee, and whether the changes are material or can just be accepted.” And as your relationship continues, it’s important to keep likes of communication open, so your banks are aware of your pipeline of projects and any changes to your business. “Although the needs of some markets mean we have to work with local banks, we use our core bank group as much as we can,” says Berg. “In joint ventures and in big projects, particularly in the US and Europe, there can be rating requirements — in those situations, it’s particularly important to have the right bank group.”
4. Consider alternative instruments
Bank guarantees are a long-established part of doing business in the construction sector. But they’re not the only instrument that businesses have at their disposal to provide assurance to trading partners. Berg explains that insurance companies offer similar instruments: “The insurance market has products such as ‘surety bonds’ (which is the main guarantee instrument for Skanska in the US) or ‘performance insurance’. “We work with a number of insurance companies, whose products are as good as the bank guarantees, and where we can negotiate identical terms. But there’s still not a general acceptance of insurance in all markets. Apart from the US we tend to use it mostly in the Nordics where it’s more familiar.”
For a large and well-regarded multinational group like Skanska, there’s a third option: the parent company guarantee (PCG). Under a PCG, a Skanska subsidiary’s obligations are guaranteed by Skanska group, relying on its credit quality and balance sheet.
Although some customers won’t accept a PCG, it’s the preferred option for Skanska, because it avoids the cost of paying a third party for a guarantee facility. As a result, Skanska can sometimes afford to offer customers better terms through PCGs — including guaranteeing the full contract value at risk. Conversely, bank guarantees will normally only pay out a percentage of the contract value on default, typically around 10%.
The right instrument must be selected on a case by case basis to meet the expected standards of the region in which you’re operating, the preferences of the beneficiary, and the optimal cost to the issuer.
5. Don’t worry, but be careful
With a carefully chosen pool of banks and insurance companies and following the best practices we’ve discussed, disputes are rare at any stage, from issue to expiry. Banks expect certain routine amendments, such as extensions, and the interpretation of bank guarantee terms is highly standardised. However, it’s worth noting that there is still important variations, and all parties should carefully scrutinise the terms of the agreement and the underlying contract.
Guarantees are a tool of last resort, and Skanska confirms that they’re rarely exercised. “I’ve been working with guarantees at Skanska for more than five years,” says Berg, “and I can count the number of claims on one hand.” Partly this is due to Skanska’s commitment to delivering on its promises, but it’s also due to careful management by Skanska’s guarantees team. Skanska takes care to avoid abusive claims by pushing wherever possible for guarantees to be conditional, so that should a dispute arise, the beneficiary requires a legal opinion or verdict from an independent assessor before the bank will issue payment. This is good practice.
To find out more about bank guarantees and how you can take advantage of them in your own business, check out our FAQ with one of Nordea’s most experienced trade finance advisers, Jennifer Gåfvels.
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