Staying Safe With Performance Bank Guarantees
Cambodian banks play a vital role in ensuring business transactions go as planned, especially in the construction sector. Still, many people don’t understand how a “performance bank guarantee” works, especially in Cambodia’s thriving building sector.
Unlike a bank guarantee that is used to strengthen general contractual relations between two parties, a performance bank guarantee is specifically applied to business agreements involving construction projects, i.e. generally between a project owner and a contractor, said Sok Piseth, who heads the foreign and new business development department at Canadia Bank.
A performance bank guarantee (also called a performance bond) is a specific guarantee that an owner of a project asks a construction company to produce via a bank to ensure that the company has the resources to complete the project and will not leave it unfinished – otherwise, the bank will be held financially responsible. In the event the contractor fails to perform a task that was agreed upon, the project owner, as beneficiary of this guarantee certificate, can file a claim against the bank.
Mr. Sok Piseth, Head of Canadia Bank’s Foreign Business and New Business Development Dpt.
“The guarantee ensures that the contractor selected by the owner is capable of completing the construction project,” said Piseth, “But what if that contractor was playing some kind of joke by not handling the work properly. How will the project owner be hurt since he or she relied on that company to complete the job?”
On construction projects, trust between project owner and contractor is essential. During bidding, project owners usually prefer contractors that offer their services for less money than the other bidders. The worry is that while a project owner might not trust a contractor to complete the project according to the terms of the agreement, a contractor might also not be sure if a developer is sincere.
“That is the main reason both parties agree to use a performance bank guarantee to gain trust,” Piseth said.
A performance bank guarantee offers different kinds of benefits to the different parties. Project owners use the guarantee to claim compensation for losses in case the contractor fails to meet the contractual agreements. For contractors, the guarantee helps them since they will not have to put down a deposit with project owners.
For example, say a contractor wins a contract for a US$10 million project with the agreement to complete the project within two years. Without a bank guarantee, the contractor doesn’t face liability if they fail to meet their contractual agreements.
But a guarantee certificate states clearly that contractors must to finish the project on time and on budget as agreed in the contract. If they don’t, project owners can claim compensation from the bank regarding any losses.
How a guarantee is made
To set up a performance bank guarantee, a contractor will need to ask a reliable bank to draw one up and assign the project owner as the guarantee’s beneficiary.
Ms. Chea Serey, National Bank of Cambodia Director General
Usually, a contractor will need to deposit from 10% to 30% of the total project cost by using his or her property deed as collateral. The issuing bank, then, will study the contractual agreement between both parties and verify that the property deed deposited by the contractor has a value equal to the amount reserved as possible compensation to the project owner.
If the bank approves, it will issue a guarantee to the contractor, who then gives the certificate to the project owner.
This performance bond can be made before or after the bidding based on negotiation between both parties. Usually project owners, since they don’t know the contractors well, ask that bidders prepare it in advance and include it in the bid documents. Normally, the performance bond states clearly the amount to be paid to the beneficiary, the guarantee term and the date to release the guarantee duty.
Internationally, performance bank guarantees are issued by banks and other intermediary companies providing this kind of service. In Cambodia, according to Chea Serey, Director of the National Bank of Cambodia (NBC), the country’s financial regulator, generally only banks can offer such guarantees – not micro-finance institutions (MFIs).
“But not every bank would want to offer such a service. It all depends on the bank’s appetite for risk and its business model,” she said.
NBC’s role is to make sure banks perform proper risk analysis and that all fees and charges are disclosed to customers in a transparent manner.
“NBC also encourages banks to introduce new and innovative, but safe, financial products to the public in order to facilitate economic and financial activities,” she said. “The rule in general, however, is that we do not intervene in the way banks conduct business unless it poses a risk to the stability to the financial system or jeopardizes consumers’ interest.”
Sok Piseth of Canadia Bank said that while performance bank guarantees can be issued by banks, private companies are also legally allowed to offer this service, but project owners and contractors need to make sure they are reliable. “It is just that the procedure to claim money will involve the court system when the guarantee is issued by private company,” he said.
While Piseth has observed that performance bond services in Cambodia are increasingly popular, NBC’s Serey worries that clients will suffer in cases where the project owner and the constructor are the same entity.
When the contractor and the project owner are the same, the buyer might require a bank guarantee that the project owner/constructor will not run away with the down payment before project completion, or that the quality of the property meets certain safety standards, she said.
“However when it is a big housing project selling smaller lots, buyers are generally intimidated by a big project owner or constructor and take the company’s promises at face value,” she said. “In addition buyers often have no incentive to get a bank guarantee because it will add to the cost of the house.”
In this situation, when everything goes as planned, it is fine, Serey stressed, but when it does not, home buyers can be hurt, losing money as well as confidence about future projects. “Small home buyers are often vulnerable when dealing with big project developers. Therefore, they may require government intervention.”
Speaking on behalf of the nation’s financial regulator, she said the government might need to step in to protect customers’ interests by acting on behalf of home buyers to make sure that housing projects are granted only to trustworthy companies with adequate resources and expertise. Or, it might be good to require a bank guarantee for projects before a license is granted.
“By doing so, in the event of default on the part of the developer, the home buyer can be compensated by the bank,” she said.
The Process of Issuing Bank Guarantee
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