Vikash Khandelwal, CEO, SREI CBL Guarantee JV, explains why guarantees or Sureties appear to be almost what the doctor ordered in trying times for the real estate industry.
Wish there was a town! Lamented one of the placards held by the agitating home buyers demanding possession of their long-delayed homes in Noida.
Earlier in August 2017, The National Company Law Tribunal admitted the plea of IDBI Bank relating to default of Rs. 526 crore loan by Jaypee Infratech Ltd, one of the companies developing Wish Town, a 1,100 acre township in Noida. Over 32,000 buyers in various projects of Wish Town are now facing uncertainty about if and when they will get possession of their dream homes as the developer faces proceedings under the Insolvency and the bankruptcy code. Around the same time, Amrapali another real estate group based in Noida is yet to deliver over 27,000 apartments in Greater Noida. Here too, three of the group’s companies have been referred to the Interim Resolution Professional under the Insolvency and Bankruptcy code.
These are not isolated incidents – A few hundred thousand buyers of apartments across the country have been left in the lurch by builders who have not been able to deliver their houses as promised at the time of booking. The projects are all delayed, some by over a decade thus causing tremendous hardship to the buyers who are required to bear the brunt of EMIs as well as rentals. The question is – Could this have been avoided? Would it have been different if we had financial instruments like Purchasers Credit Protection and Property Deposit Bonds available to the Indian Home buyer? A purchaser credit protection guarantee protects residential property buyers from the insolvency of the builder.
In hindsight, these financial instruments which are a part of a larger bouquet of offerings called Guarantees or Sureties appear to be almost what the doctor ordered in trying times for the real estate industry that is battling poor sales, depleting cash flows, combative buyers, an aggressive judiciary and a widening trust deficit.
Tracing the origin of Guarantees & Bonds
The concept of Bonding or Guaranteeing as it is also called is perhaps the oldest as it was used to bind oral contracts in the absence of the written word. While the exact origin of bonding is not yet known, it is widely believed that they have been around since 2750 BC. Sureties in their most primitive forms are also recorded in the business commerce records of ancient Sumer and Phoenicia civilisations. However, it was only around 150 AD that the Romans developed the laws of Bonding, most of which are still relevant today. The Sumerians in Southern Mesopotamia were also amongst the earliest urban societies to emerge in the world more than 5,000 years ago. They also developed a writing system whose wedge-shaped strokes would influence the style of scripts in the same geographical area for the next 3,000 years. They are also considered as the Fathers of Bonding.
Evolution of Sureties
Sureties have also played a major role in US and Canada’s growth since they emerged as a modern North American industry in the late 19th and early 20th centuries. Even today in the US, as alternative procurement methods such as P3 have grown in popularity, surety bonds have continued to support billions of dollars of investments in P3 projects. It is also notable that in the US and in many of the developed countries of the world, surety bonds are mandated by law on public works projects as alternative forms of financial security such as bank guarantees or letters of credit do not provide 100% performance protection and nor do they assure a competent contractor. In many countries, sureties have helped the smaller businesses bid for large project which they otherwise wouldn’t have qualified for.
What are Sureties & Guarantees?
A surety bond is a risk transfer mechanism where the surety company assures the project owner that the contractor will perform a contract in accordance with the contract documents. In the Indian context, Section 126 of the Indian Contract Act, 1872 defines a ‘contract of guarantee’ as a contract to perform the promise, or discharge the liability, of a third person in case of his default. The person who gives the guarantee is called the ‘surety’; the person in respect of whose default the guarantee is given is called ‘the principal’, and the person to whom the guarantee is given is called the ‘obligee’. A guarantee is therefore a promise to answer for the debt, default or miscarriage of another.
Changing traditions in India
In India, bank guarantees have traditionally been used extensively where ever guarantees were required whether it was for bidding for a project, submitting performance guarantees or any other requirement of a deposit or a security. The practice is common place in the construction and the infrastructure industry where construction contracts require securing the performance of the contractors’ obligation. These are usually provided by contractors to the principal and /or by subcontractors to contractors, in order to assure performance of construction and defects obligations, as well as in circumstances where there has been an advance payment for supplies requiring a long lead time. While the bank guarantees address the requirements of credibility and the certainty of payment in the event of a call on the guarantee, it also requires the applicant to put up collateral against the facility availed and eats in to the working capital limits of the entity thus restricting liquidity available with the contractor.
Infrastructure development in India
The Government of India today is pursuing a fast paced and focused approach towards creation of world class infrastructure in the country. An estimated US $455 billion is expected to be invested towards upgradation and development of infrastructure including power, roads, shipping, urban infrastructure etc. over the next 5 years, thus making India the 3rd largest construction market in the world behind only the US and China. With so much at stake, it’s also imperative that the chronic inefficiencies of the past in the form of poor execution, project delays and cost over runs are addressed. As per data released by MOSPI, an average of 40% of the projects have cost over runs of an average of 15% surge to the overall project cost. Hence between 2010 and 2015, the cost overrun in delayed projects has resulted in increase in the original cost of the projects, to the extent of approx. Rs. 1,09,359 crores in absolute terms.
How Sureties address the inefficiencies of the past
Sureties, if introduced in the country, can play a very important role in addressing such inefficiencies of the past as it has done in various geographies across the globe. The entire guarantee requirements of the country are currently catered to by the Banks who are “generalist” offering guarantees as one of their products without a clear understanding of any particular sector, while Sureties are “specialist” with depth of expertise and bring immense value to the implementation of the contracted terms. A specialized Guarantee provider conducting the holistic assessment of the company, as an expert, adds to the credibility of the work and not just the financial underwriting.
Sureties depend on their underwriting expertise to assess the risks associated with the project; they usually do not require cash collaterals or margins to issue a performance bond or a security deposit guarantee. The Indian Government has committed to heavy investments, to a tune of nearly US $455 billion, in the upgradation and development of infrastructure in the country. As with previous economic cycles, the proposed increase in construction activity will put added pressure on contractors’ working capital, which will trickle down to subcontractors. In this context, each contract requires the contractor to put up a performance bond by way of a bank guarantee to the extent of approximately 10% of the project value. This would require over US $45 billion of working capital to be tied in from the banking limits sanctioned to the contractor, a large part of which can get released if we are to consider guarantees issued by a Surety. This number will go up significantly if we are to consider the cash margin that the contractor may have to put up to obtain the bank guarantee.
Sureties help bring capabilities by way of a rigorous pre-qualification process on the contractor’s ability to fulfil the obligations of the contract. It also helps weed out the inefficient/incapable/poor performing contractors. That is why in the US highway industry, one of the main methods to prequalify a contractor is whether or not a performance bond can be secured from a commercial surety.
Benefits of Sureties
The benefits of Sureties can be immense from an economical and an execution standpoint as they help protect the interests of the tax payer, the public and private project owners, the lenders, and the prime contractors from the potentially devastating expense of contractor or sub-contractor failure.
To wrap up, I will quote the results of a study based on case studies in five State Departments of Transportation (DOTs): Iowa, Oklahoma, Utah, Virginia, and Washington, structured interviews were also conducted with members of the construction contracting sector and the surety industry. The paper finds that while average default rates are less than 1.0% and a performance bond adds an average of 1.5% to the cost of every construction project, both Department of Transportation and contractors would be reluctant to eliminate performance bonds from the industry. Therein, lays the paradox: construction project owners are willing to pay an additional 1.5% to protect itself from an event that happens less that 1.0% of the time.
The research paper further states that between the years 2007 to 2011, defaults were reported by the State DOTs for 37 projects out of a total of 40,000 projects. Indication of having a relationship of Surety Company and the contractor at an enterprise level has been ranked as the key reasons of this risk management – Definitely food for thought for our lawmakers!