Bank Guarantee

A move that may prove to be a game-changer but the proof lies in the pudding

A government procurement contract (GPC) for goods and/ or services usually requires the elected counterparty (Contractor) to furnish a bank guarantee (BG) of upto 5-10% of the contract value as performance security, as per General Financial Rules 2017. Rising non-performing assets, in recent years, have prompted banks to exercise greater caution while issuing BGs, due to which, the cost of procuring a BG has gone up from 20-40 basis points to 50-130 basis points and the cash margin required for securing a BG has also increased from 15-20% to 40-100% of the amount of the BG. Owing to these factors, the procurement of a BG has become increasingly cumbersome for Contractors and they have been long-advocating the need for an alternative to BGs.

In a bid to offer some respite to Contractors, Union Finance Minister Ms. Nirmala Sitharaman, in the Union Budget 2022-23, had announced that a surety bond (SB) can be used as a substitute for a BG in GPCs. While both BGs and SBs aim to protect a party to the contract against losses suffered by it due to a breach or non-performance by the counterparty, an SB, unlike a BG, is not required to be collateralised through cash margins that are kept in the form of fixed deposits. An SB is a financial instrument that is underwritten by an insurance company against the financial strength of an entity procuring the SB, in consideration of payment of premium by that entity. Additionally, unlike a BG that has to be renewed periodically, an SB remains valid for the entire tenor of the contract and, therefore, eliminates the costs incurred by Contractors for renewal of BGs. As the premium for an SB can be paid from the working capital lines availed by Contractors, the substitution of BGs with SBs will allow the Contractors to efficiently manage their cash flows and they will no longer be required to keep idle cash reserves that had hitherto been set aside for providing cash margins for availing BGs.

The acceptance of SBs for government procurement will not only be beneficial for Contractors, but also provide an additional stream of revenue to insurance companies. Earlier this year, the Insurance Regulatory and Development Authority of India had issued the IRDAI (Surety Insurance Contracts) Guidelines, 2022 (Surety Guidelines), that laid down the foundation for the development of surety insurance business in India. The Surety Guidelines came into effect on April 1, 2022, and the entry of insurance companies in the government procurement space will offer an alternative financial backstop to the Contractors who had earlier been dependant on banks for procuring a BG.

While the benefits of SBs over BGs cannot be gainsaid, the development of an SB-market in India will require certain clarifications on the ambiguity pertaining to the recourse available to insurance companies in case of default by Contractors. While Clause 6.2 of the Exposure Draft on IRDAI (Surety Insurance) Guidelines, 2021 (issued on September 8, 2021), expressly provided for securing SBs through personal guarantees of the promoters, the provision has been omitted from the final draft of the Surety Guidelines. The absence of clarity in this regard may have a direct bearing on the premium that will be required to be paid by Contractors and a timely resolution of this issue will go a long way in supporting the growth of the SB-market in India.

With the Budget announcement having been implemented through an amendment to the General Financial Rules 2017 and the Surety Guidelines coming into effect from April 1, 2022, the stage is set for testing the merits associated with SBs in India. The feasibility of SBs has already been tried and tested in jurisdictions such as the United States, Brazil, Australia and Philippines, and the financial flexibility offered by SBs may very well prove to be a game-changer in the way Contractors manage their cash flows. Once the success of SBs is established in relation to government procurement, the substitution of BGs with SBs may also be explored in contracts entered into between private parties. While certain costs, such as payment of premiums on SBs, will still be incurred, the proof of advantage offered by SBs over BGs will continue to remain in the pudding, till the market for SBs has matured from its current embryonic state.